Muni Bonds Need Governments to Fight for Them

The tax-free status of municipal bonds is under attack. If eliminated, borrowing could get more expensive for states and localities.

As lawmakers move to trim the national deficit, tax experts say that state and local government officials that leave themselves out of the debate about municipal bonds could suffer a major blow.

Tax-exempt municipal bonds, which finance infrastructure projects at the state and local level, have been targeted by policymakers looking to boost tax revenue. But advocates for state and local governments argue that tacking on more costs to the bonds would push some investors out of the market, making it tougher for governments to secure financing.

Interest earned by municipal bonds has been exempt from federal taxes since the tax code was adopted in 1913 -- an incentive that's helped create a $3.7-trillion municipality securities market. John Buckley, chief Democratic tax counsel for the U.S. House Ways and Means Committee, said at a recent event that if state and local governments don't make their case for municipal bonds, they risk losing their tax-free benefit as Congress crafts deficit reduction plans in the coming months.

“State and local tax-exempt bonds are under attack,” Buckley said at a discussion hosted by the Tax Policy Center. 

In 2010, a bipartisan commission proposed revoking the tax-exempt status, and last year, President Barack Obama's failed jobs package was partially funded by revenue derived from capping the tax-free exemptions enjoyed by the wealthy. That cap would have applied to earnings on municipal bonds. 

As investments from older generations taper off, and individuals increasingly pool their investment assets in other plans like 401ks, Buckley said, “the appetite for interest-bearing investment in taxable accounts is shrinking.” He added that state and local policymakers need the tax exemption to drive up demand and said they should brand the bonds as subsidies for state, city and town governments -- not just for investors.

“That’s where I think you win the debate," he said. "But you need to enter into the debate.”

Because the profits from state and local government bonds aren't taxed, investors are willing to accept a lower interest rate. Eliminate that benefit, and municipalities would have to offer higher returns to investors. That would increase the cost of borrowing, and the cost would fall on state and local taxpayers.

While governments argue they're the beneficiaries of the exemption, one could also argue that the tax-exempt status for municipal bonds is essentially a subsidy for the wealthy, since it primarily benefits investors in the highest tax brackets.

Harley Duncan, formerly the executive director of the Federation of Tax Administrators, echoed Buckley's call for state and local governments to be more effective at lobbying on Capitol Hill to preserve the status quo for bonds. He said the declining power of advocacy groups like the National Governors Association -- which he partially attributes to increasingly strained partisan divisions -- has prevented serious talks between the federal and local and state governments. This week, the governor of Maine announced plans to pull out from the organization. A spokesperson for the NGA did not return phone calls for this article.

“We’re the only ones in town talking about this,” Duncan said about the muni bonds, pointing out that the federal government does not measure the financial impact on state and local governments, since there isn't a framework for state and local budget analysis.

Communications manager for the Texas Medical Center Health Policy Institute