Selected Issues in Tax Reform: Federal Subsidies for Municipal Bond Interest

April 16, 2025

Selected Issues in Tax Reform: Federal Subsidies for Municipal

Bond Interest

The federal tax code includes subsidies for interest income

earned on state and local (municipal) bonds. Municipal

governments issue bonds to investors to finance

investments in exchange for interest payments and the

eventual repayment of principal (the amount borrowed).

Federal bond subsidies have been subject to sustained

legislative interest, including changes enacted by P.L. 11597 (often referred to as the Tax Cuts and Jobs Act, or

TCJA) and the Infrastructure Investment and Jobs Act of

2021 (IIJA; P.L. 117-58). This In Focus summarizes the

subsidies provided under current federal law, discusses

changes enacted in recent Congresses, and briefly examines

relevant policy issues.

Summary and Legislative Background

The federal government subsidizes state and local debt

through three policies: (1) all interest income earned from

public purpose bonds is excluded from federal income

taxation; (2) interest income earned from qualified private

activity bonds (PABs) is excluded from federal regular

income taxation; and (3) a tax credit may be claimed on

interest income in lieu of the exclusion in some cases,

though authority to issue new tax credit bonds has expired.

Table 1. Projected Tax Expenditures on Federal Bond

Subsidies, FY2024-FY2028

Billions of dollars

Reduced

Revenues

Increased

Outlays

Total

Tax-Exempt

Bonds

131.0

—

131.0

Qualified

PABs

49.9

—

49.9

Tax Credit

Bonds

1.5

13.3

14.8

Source: Joint Committee on Taxation, Estimates of Federal Tax

Expenditures for Fiscal Years 2024-2028, JCX-48-24, December 2024.

Table 1 shows Joint Committee on Taxation (JCT)

estimates of the budgetary effects of federal bond subsidies

from FY2024 to FY2028. The federal bond subsidies are

projected to provide a total of $196 billion in benefits over

five years. That annual subsidy represents about 1% of the

current municipal debt stock: the Federal Reserve estimated

that state and local governments had $3.3 trillion in debt

issuances outstanding in the last quarter of 2024.

Tax-Exempt Bonds

Bonds are considered to be for a public purpose if they

satisfy either of two criteria: (1) less than 10% of the

proceeds are used directly or indirectly by a

nongovernmental entity; or (2) less than 10% of the bond

proceeds are secured directly or indirectly by property used

in a trade or business. Bonds that satisfy either test are

called “governmental” bonds and can be issued without

federal restriction. The federal government subsidizes the

cost of governmental bonds by excluding interest income

earned by investors on those bonds from federal income

taxation. The exclusion lowers the cost of debt for state and

local governments by allowing them to borrow at lower

interest rates than would otherwise apply if the interest

income were taxable.

The lower interest rates arise because in most cases

investors will be indifferent between taxable and taxexempt bonds of equivalent risk if their after-tax return is

identical. For example, consider a taxpayer in the 37% tax

bracket who seeks to invest in a taxable bond with a 10%

interest rate or a tax-exempt bond with a 6.3% interest rate.

The taxability of the bond with the 10% interest rate makes

the investor’s after-tax income identical to that of the taxexempt bond with a 6.3% interest rate. Thus, state and local

governments could raise capital from investors at an interest

cost 3.7 percentage points lower than a borrower issuing

taxable debt.

The direct cost to the federal government of tax-exempt

bonds is the individual and corporate income tax revenue

forgone. In the example above, a taxable bond with a 10%

interest rate would have generated federal tax revenue equal

to 3.7% (37% x 10%) of the bond’s principal value

annually.

Some bonds, called refunding bonds, are issued to replace

outstanding bonds with less favorable terms. There are two

types of refunding bonds: current refunding bonds, which

are redeemed within 90 days of the refunding bond issue

date, and advance refunding bonds, which are issued in

such a way that both the original and refunding bonds are

outstanding longer than 90 days. Only current refunding

bonds are eligible for a federal tax subsidy, as P.L. 115-97

repealed the ability to issue tax-exempt advance refunding

bonds. Refunding bonds may be issued for public or private

purposes.

Qualified Private Activity Bonds

Bonds that fail both public purpose tests are termed privateactivity bonds (PABs) because they provide significant

benefits to private individuals or businesses. These projects

are generally ineligible for tax-exempt financing. However,

activities that fail each test but that Congress considers to

provide both public and private benefits are categorized as

qualified and can be financed with qualified PABs, which

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Selected Issues in Tax Reform: Federal Subsidies for Municipal Bond Interest

are tax exempt. Only qualified activities included in the

federal code can be financed with tax-exempt PABs. About

30 types of issuances are eligible for the qualified PAB

subsidy. The IIJA created two new qualified PAB

categories (for certain broadband projects and carbon

capture facilities) and increased an overall limitation on the

issuances available for certain highway and surface transfer

facility bonds.

Some qualified PABs are also subject to an annual, statespecific issuance cap intended to limit the benefits provided

through the subsidy. The value of bonds issued for these

activities by all governmental units in a state is limited to

the greater of $130 per resident or $388.8 million in 2025.

Tax Credit Bonds

Tax credit bonds (TCBs) were created as an alternative to

tax-exempt bonds. TCBs provide a tax credit or direct

payment proportional to the bond’s face value in lieu of the

tax exemption. Unlike tax-exempt bonds, the value of the

credit is not dependent on the investor’s marginal income

tax rate. The relative appeal of TCBs and tax-exempt bonds

varies with bond interest rates, tax status of the investor,

and underlying economic conditions.

All authority to issue tax credit bonds was repealed by P.L.

115-97, though most TCBs in the tax code were not eligible

for new issuances prior to the law’s enactment. Outstanding

TCBs are still held by the public and thus still receive the

federal subsidy. Most TCBs were designated for a specific

purpose, including public school construction and

renovation, clean renewable energy projects, and

refinancing outstanding government debt in regions

affected by natural disasters.

Policy Considerations

Certain goods and services provided by state or local

governments benefit both residents, who pay municipal

taxes, and nonresidents, who pay minimal if any municipal

taxes. State and local taxpayers may be unwilling to provide

these services to nonresidents without compensation, which

could cause the services to be underprovided relative to

their public benefits. In theory, such spillover effects could

justify some federal financing for state and local projects.

Subsidizing debt issuance specifically has the benefit of

harmonizing the timing of the subsidy with the period over

which bond-financed facilities provide services. State and

local taxpayers lay claim to the benefits from these facilities

through residency and relinquish benefit claim when they

move. State or local officials may therefore prefer to spread

the timing of the payments more evenly with the provision

of services, precisely the function served by long-term bond

financing.

State and local governments typically must plan their

budgets one to two years in advance, and often are required

to balance some or all of their incoming and outgoing

payments. Unforeseen circumstances can undermine such

plans and cause a revenue shortfall, which must be financed

with short-term borrowing. Timing issues may also create

the necessity to borrow within an otherwise balanced fiscal

year. Finally, temporarily high interest rates that prevail at

the time bonds are issued may induce short-term borrowing

in anticipation of a drop in rates. Federal subsidies reduce

the costs of these activities, though the economic rationale

behind the transfer of such costs from municipal taxpayers

to federal taxpayers is less clear.

Critics of the subsidies for municipal debt believe that they

represent a suboptimal allocation of federal resources, as

some observers believe that the subsidies for municipal debt

could be better used on some combination of direct federal

investment in municipal infrastructure, other federal

programs, or deficit reduction. Moreover, since the amount

of capital investors are willing to loan is limited, offering

subsidies for municipal debt may increase the interest costs

for other types of debt issuances, including for federal

borrowing and private financing.

The bond subsidies also affect the distribution of the federal

tax system. Benefits from tax-exempt bonds and qualified

PABs are directly proportional to the investor’s marginal

tax rate, meaning that higher-income taxpayers benefit

more from them than do lower-income taxpayers. Higherincome taxpayers also tend to have more disposable capital

to loan to municipal governments, making them more likely

to receive such benefits.

Recent Reform Proposals

The Congressional Budget Office published an option in its

December 2024 Options for Reducing the Deficit report that

would eliminate the tax exemption for new qualified PABs.

The JCT estimated that proposal would increase revenues

by about $43 billion over the FY2025-FY2034 period.

An early version of P.L. 115-97 considered in the House

prior to its enactment included language that would have

(1) repealed all new issuance authority of qualified PABs;

and (2) amended the definition of tax-exempt bonds so that

issuances for the construction of professional sports

stadiums did not qualify for the exemption. P.L. 115-97 as

enacted did not include that language.

Recently introduced legislation that would modify federal

bond subsidies has included, but is not limited to

• legislation that would create new qualified PAB

categories, including for spaceports (S. 3823 and H.R.

7470 in the 118th Congress) and for replacement of lead

service lines in public water systems (S. 726 and H.R.

6985 in the 118th);

• legislation that would expand bond subsidies, including

expanded use for tribal governments (S. 5048 in the

117th), reinstatement of advance refunding bonds (S.

1453 in the 118th), and reinstatement of TCBs for certain

infrastructure projects (S. 1403 in the 117th); and

• legislation that would restrict bond subsidies, including

repealing bond subsidies for sports stadiums (S. 392 and

H.R. 993 in the 118th), and denial of bond issuances for

certain governments (H.R. 1879 in the 119th).

Grant A. Driessen, Acting Section Research Manager

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IF12969

Selected Issues in Tax Reform: Federal Subsidies for Municipal Bond Interest

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