Read §§ 103 and 141. 1
Interest derived from a state or local bond is excluded from a taxpayer’s gross income. § 103(a). This exclusion does not extend to interest derived from a “private activity bond,” § 103(b)(1), or an “arbitrage bond,” § 103(b)(2). 2 This provision has always been a part of the Code. There may have been some doubt about whether Congress had the constitutional power to tax such income.
It might appear that this would encourage investors to choose to purchase the bonds of state and local governments. After all, the interest income that such bonds generate is not subject to tax, whereas other investment income is subject to federal income tax. The investor should be able to keep more of his/her income. However, both borrowers (state and local governments) and investors know that the interest on such bonds is not subject to federal income tax. Hence, state and local governments are able to borrow money at less than prevailing interest rates, i.e., the rate that any other borrower would have to pay. If the market “bids down” the interest rate to the point that taxpayers in the highest tax bracket (now 39.6%) are no better off than they would be if they had simply purchased a corporate bond carrying equivalent risk and paid the income tax on the interest that they receive, the exclusion would function “only” as a means by which the U.S. Treasury transfers the tax revenue that it must forego to state and local governments. There are some (potential) economic distortions that this exclusion causes:
- If there are enough taxpayers in the highest tax bracket to “clear the market” for state and local bonds, the interest rate on such bonds should gravitate to (1 − λ)*(prevailing interest on corporate bonds), where λ denotes the highest marginal tax rate. If this is the case, all of the tax that the U.S. Treasury foregoes is transferred to state and local governments.
If one state has been profligate in its spending and now finds that it must borrow enormous amounts on which it will be paying interest far into the future, should taxpayers in other states care?
- But if there are not enough taxpayers in the highest tax bracket to “clear the market” for state and local bonds, state and local governments must offer an interest rate higher than (1 − λ)*(prevailing interest on corporate bonds). Perhaps it will be necessary to entice some taxpayers in the second-to-highest or even third-to-highest bracket. The effect of this is to give taxpayers in the highest tax bracket a windfall, i.e., an after-tax return on state and local bonds that is higher than the after-tax return on corporate bonds. In this case, not all of the foregone tax revenue is transferred from the U.S. Treasury to state and local governments; some of it is transferred to taxpayers in the highest tax bracket.
- How will this affect the market for corporate bonds?
- In effect, those who invest in state and local bonds have the power to “vote” to have some of their tax dollars go to state and local governments rather than to the federal government. Most of the (rational) voters will have high incomes.
- There is no limit to the amount of interest that a taxpayer may exclude under this provision. 3 Hence state and local governments may be encouraged to borrow more than they otherwise would. The laws of some states limit the amount that they can borrow.
- State and local governments may elect to finance “too many” capital projects – e.g., highways, schools, government buildings – by issuing bonds, as opposed either to foregoing such expenditures or by procuring necessary funds in another manner, e.g., raising taxes.