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Municipal bonds differ from most other securities because of their special tax status. Interest payments on bonds issued by state and local governments in the United States are exempt from federal income tax. Most states with income taxes also exempt their own interest payments from tax. The federal income tax exemption for municipal bond interest is usually justified on the grounds that it reduces borrowing costs for states and localities, thereby facilitating their investment in public infrastructure.

When the federal income tax was enacted in 1913, there was some question as to the constitutionality of such a federal tax on interest paid by states and localities. In 1988, the Supreme Court affirmed the federal prerogative to tax such interest in the case of South Carolina v. Baker. The tax exemption for municipal bond interest should therefore be viewed in the same way as any other tax expenditure, namely as a political decision about the structure of income taxation.

There are three types of municipal bonds: general obligation bonds, which are backed by the ‘full faith and credit’ of the borrowing jurisdiction; revenue bonds, which are backed by the stream of income from a particular project such as a highway or publicly operated power plant; and private purpose bonds, which are tax- exempt bonds issued by private borrowers with the authorization of a state or local government. Only general obligation or ‘GO’ bonds have a potential claim on the tax revenues of a state and local government. The interest payments on revenue bonds are dependent on the revenues associated with the project that issued the bonds. Private purpose bonds are typically used to finance private sector projects that are deemed beneficial to the state or local economy or community; in practice these bonds finance a wide range of activities. The market value of outstanding tax-exempt bonds in 2006 was 2.3 trillion dollars according to estimates from the Federal Reserve Board Flow of Funds Accounts. GO bonds account for roughly 40 per cent of outstanding tax-exempt debt.

While municipal bond interest is generally exempt from federal income taxation, the relevant tax rules are complicated in some situations. For example, retirees who receive Social Security benefits must include tax-exempt bond interest in the income concept that is used to determine how much of their Social Security income is included in taxable income. In addition, the interest paid on many private purpose bonds is taxable under the federal alternative minimum tax (AMT). While the AMT affected only 3.5 million taxpayers in 2006, projections suggest that provided there are no changes in the basic structure of the tax, it will apply to more than 20 million taxpayers by 2010. Bonds that are not exempt from the AMT typically offer investors a higher yield than bonds that pay interest that is completely tax exempt.

In part as a result of changes in the tax law, there have been changes over time in the ownership patterns for municipal bonds. Prior to 1986, commercial banks were the primary holders of short-term municipal bonds while households and insurance companies were the primary holders of long-term municipals. The Tax Reform Act of 1986 sharply limited the incentives for banks to hold tax-exempt bonds, and since then the ownership mix has shifted towards households. According to Flow of Funds data for the third quarter of 2006, households were the direct owners of 37 per cent of outstanding municipal bonds. Mutual funds, which are largely owned by households, accounted for another 33 per cent. Commercial banks hold seven per cent, while property and casualty insurance companies hold 14 per cent.

Investors who hold municipal bonds avoid paying income taxes on their interest income, but they pay an ‘implicit tax’ when the pre-tax interest rate on municipal bonds is lower than that on an equally risky taxable bond. The yield spread between taxable and municipal bonds is often summarized by the implicit tax rate. This is the value of θ for which (1 – θ)RT = RM where RT is the yield on newly issued Treasury bonds and RM is the yield on prime grade municipal bonds of comparable maturity. This relationship is only satisfied by newly issued taxable and municipal bonds under the assumption that investors plan to hold these bonds to maturity. Poterba (1986) shows that with forward-looking investors, the implicit tax rate measured from current bond yields reflects not just current marginal tax rates on taxable interest but future marginal tax rates as well. For seasoned bonds, the tax treatment of differences between the purchase price of the bond and the par value complicates the calculation of the implicit tax rate. More generally, when investors sell their bonds before maturity, changes in bond prices may result in taxable capital gains or losses. The definition of the implicit tax rate also assumes that Treasury bonds and prime grade municipals are equally risky, an assumption that some might question.

The implicit tax rate on municipal bonds varies across bond maturities at a given point in time, and it varies over time in part as a result of changes in tax rates and tax rules. During the first week of 2007, the interest rate on 30-year GO bonds with an AAA rating was 4.14 per cent, while the yield on a 30-year Treasury bond was 4.59 per cent. The implicit tax rate based on these values is 9.8 per cent, well below the top statutory marginal tax rate on individual investors, 35 per cent. The yield spread between AAA-rated municipal bonds and AAA-rated corporate bonds is larger, but this comparison raises the challenge of risk adjustment. For the same week, the yield on one-year AAA-rated municipals was 3.53 per cent, while that on one-year Treasury bonds was 4.92 per cent. The implicit tax rate at the one year maturity was therefore 28.3 per cent.

One of the challenges in analysing the municipal bond market is explaining why implicit tax rates are substantially below top statutory rates. Chalmers (1998) discusses various potential explanations and rejects the possibility that differential default risk explains this long-standing pattern. The yield curve puzzle has motivated research on the relative pricing of taxable and tax-exempt bonds. Green (1993) argues for moving beyond yield-to-maturity analysis, such as that underlying the foregoing implicit tax rate computations, and developing a more subtle analysis of the tax-exempt bond market.

The key insight in Green (1993) and several subsequent studies is that fully taxable individual investors are unlikely to regard newly issued tax-exempt bonds and newly issued taxable bonds as competitive investment alternatives. If such investors chose to hold taxable bonds, they should do so by holding bonds that generate income in a way that generates less tax liability than a newly issued bond. The opportunities to earn bond returns that face a lighter tax burden are greater at longer than at shorter maturities, because divergences between the purchase price of a bond and its par value are potentially greater at long maturities. This role of tax- wise investing appears to receive empirical support in yield curve comparisons at different maturities. It may help to explain why implied tax rates in the municipal bond market are often lower for longer-maturity than for shorter-maturity bonds.

Whether the policy of exempting interest on state and local government bonds from federal taxation is an efficient method of encouraging capital formation by states and localities is a long-standing subject of debate. The answer turns on the difference between the implicit marginal tax rate on municipal bonds, which determines the interest saving of state and local government borrowers, and the weighted-average marginal tax rate of municipal bond investors, with weights equal to the tax-exempt interest receipts of each investor. The latter determines the federal government’s revenue cost from exempting interest on state and local government obligations from tax. If the revenue cost exceeds the interest saving, it would cost less for the federal government to provide cash transfers to state and local governments equal to the amount of their current interest saving, while taxing interest on their bonds, than to pursue the current policy of tax exemption. In 2002, the weighted-average marginal tax rate for individual investors who received tax- exempt interest was 30.2 per cent. Feenberg and Poterba (1991) describe the calculation of such marginal tax rates. Since the implicit tax rate on 20-year municipal bonds and Treasuries varied between ten and 20 per cent during calendar 2002, the revenue cost of the exemption for households appears to exceed the interest saving for state and local government borrowers.

The progressivity of the federal income tax schedule is a key determinant of the efficiency of policies that exempt interest from taxation. When the yield spread between taxable and municipal bonds is determined by the marginal tax rate of the lowest tax rate investor who holds those bonds, but the revenue cost is determined by the weighted average marginal tax rate of the investors who hold municipal bonds, then the efficiency cost of the tax exemption will be greater when the top marginal tax rates affect many but not all municipal bond investors, and when the top rates are substantially higher than the rates on lower-income households.

When investors have access to taxable and tax-exempt bonds of equal risk, market equilibrium should involve investor clienteles in which investors segment themselves according to their tax rates. High tax rate investors should hold tax- exempt bonds, while low tax rate investors should hold taxable bonds. In practice, this separation does not occur. Poterba and Samwick (2003) show that among households that hold tax-exempt bonds, 55 per cent also hold taxable bonds. In contrast, only 15 per cent of the households that hold taxable bonds also hold tax- exempt bonds. There are risks inherent to holding municipal bonds, such as the risk of tax change, that are difficult to hedge and may incline investors to diversify their portfolios. This may explain why most investors who hold municipal bonds also hold taxable bonds.

There are many innovative products in the municipal bond market, including variable rate municipals, insured municipal bonds, and zero coupon tax-exempt bonds. The bonds issued by several large issuers, particularly large states and revenue authorities, trade in active after-markets, but the markets for many smaller municipal bond issues are not very liquid.

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