With congressional Republicans considering a menu of revenue-raising options to offset tax cuts, one potential item has sent shivers through state and local finance officers: lifting the tax exemption on municipal bond interest. It’s a feature of the tax code that lowers borrowing costs and helps fund infrastructure projects.
Under the exemption, bond buyers don’t have to pay taxes on the interest they collect from bonds. That makes municipal bonds an attractive investment and it lowers the cost of debt for cities and other government entities, pumping billions into local infrastructure. Cities issued a record $513 billion worth of bonds last year, $450 billion of which were tax-exempt.
But why is municipal bond interest tax-exempt in the first place? It was never an intentional policy choice. Congress included the exemption in the Revenue Act of 1913. At the time, they were following a Supreme Court decision finding that the federal government lacked constitutional authority to tax municipal bond interest.