From the iconic Golden Gate Bridge to Chicago’s Millennium Park, municipal bonds (“munis”) have helped states and localities to raise the funds necessary to build some of our country’s most ambitious capital projects. And they’re still alive and well today – between 2003 and 2012, states and other localities invested $3.2 trillion in infrastructure projects around the country through municipal bonds, 2.5 times more than similar federal investments.
Alongside offering bondholders an opportunity to directly improve their communities, one of the principal financial incentives that has attracted investors is the fact that, in many cases, the returns on municipal bonds are exempt from some federal, state and local income taxes.
Munis that fund projects meant for the public good are exempt from federal taxes.
At the state level, each state has its own laws that govern whether bonds are exempt from state taxes. Generally, in most states, if the bond is issued in that particular state, then individuals are not taxed on the income interest. However, if the bond is issued from by an out-of-state issuer, many states will not offer a tax exemption from that income interest.
For example, let’s say you earn $100,000, live in California, and invested in municipal bonds that are exempt from federal and state taxes. You bought 5-year bonds that have an interest rate of 3%. If you’re married and filing jointly, your tax equivalent yield is 4.25%. If your tax filing status is single, the tax equivalent yield is even higher at 4.4%.
The municipal bond tax exemption is used to make investing in public projects more attractive to investors. It enables local governments to pay lower interest compared to other investments, such as corporate bonds. Last year, governments issued more than $400 billion of municipal bonds to fund important public projects.
However, some lawmakers are questioning whether municipal bonds should be tax exempt. Opponents argue that the exemption causes governments to spend too much money and be fiscally irresponsible, since the subsidy allows the costs to be higher than the expected benefits. It’s a classic economic argument, but it lacks nuance.
For example, if a state decides to build a highway at a cost of $20 million with an expected economic benefit of $18 million, the state would likely decide not to build that highway. However, with a tax incentive of $2.5 million, they would likely go ahead with that project, providing a socially and economically beneficial investment to the community.
The debate over whether this tax exemption should exist continues at the highest levels of government. President Obama’s proposed budget for fiscal year 2017 called for limiting the tax exemption, a measure that would raise the costs of state and localities by $17 billion. Given the pressure, we should explore how this investment mechanism can continue to provide value to investors, communities, and public entities
It’s clear that this subsidy can help spur infrastructure investments within states while directly benefiting its residents, but the subsidy isn’t cheap for the federal government. In fiscal year 2014, the cost in foregone tax revenues amounted to $29 billion, with although some argue that very wealthy citizens have benefited the most from these tax breaks. Politicians can easily point to these figures as a reason to eliminate the subsidy.
But the question is whether the costs in foregone federal funds outweigh the benefits to investors, states, and localities.
One argument against the tax exemption on municipal bond interest is that it is most valuable for investors in the top income bracket. For example, a muni bondholder in the highest income bracket, where income is taxed at 35 percent, saves $35 for every $100 invested. A buyer in the 25 percent income bracket, though, would only save $25. Nevertheless, this argument doesn’t acknowledge two key points: 1) investors in lower income brackets still benefit from this subsidy and 2) even if citizens in the highest income brackets are the ones benefiting monetarily from the tax exemption, all residents who use the public infrastructure that was built due to munis also clearly reap the rewards.
Opening Up the Market
There’s another solution – facilitating wider market access. Opening up the market enables a wider range of people to invest in municipal bonds. By lowering the barrier to entry, more people in more communities can make investments that are closer to home and also get the attractive tax benefit.
Opening up the market should be a bipartisan issue. Fiscal conservatives should prefer this approach because it supports smaller borrowers. If smaller borrowers find it difficult to access the municipal bond market, the only alternative is for them work through consolidated government entities, giving far-away bureaucrats the power to make infrastructure decisions on their behalf. Democrats, especially those who champion increased infrastructure investments, should support this approach because it encourages increased participation and investment in public infrastructure and services.
Let’s unlock new opportunities of civic capital formation and enable communities to more easily invest in public projects that directly benefit them.
If this is what you think municipal bond investments should look like, and if you think that more people should have the access and the ability to invest in their communities, contact your member of Congress and let them know that it’s time to put the public back into public finance.
So the next time you walk past a public high school, community park, or protected bike line, ask yourself how these projects get funded. You’ll quickly realize the value and importance of tax-exempt municipal bonds.