Policy Changes and Management
Studies in Fiscal Federalism and State–local Finance series
Chapter 2: The tax exemption of municipal debt
A defining characteristic of the municipal securities market is the tax-exempt status of most municipal bonds. The interest paid on most municipal debt is not taxable. While increases in the principal value of the municipal bond are taxable as capital gains income, the interest income to the bondholder is not taxed as federal gross income. Section 103(a) of the Internal Revenue Code of 1954 specifically exempts municipal bond interest from the federal income tax unless otherwise indicated in law. The tax-exempt feature found on most municipal debt separates the municipal market from all other debt markets. In 2011, over 90 percent of new debt was tax-exempt. We know of no other public financial market in the world where the national government securities are taxable and those of the subnational governments are tax-exempt. The tax-exempt feature has historically been a source of continuing controversy at the federal level. The legal basis of the tax exemption is now widely recognized as solely one of federal privilege. Thus, Congress could pass and the President could sign a bill taking away the federal tax exemption on future debt issues, and state and local governments would have no judicial redress. This chapter reviews the constitutional, judicial and legislative underpinnings of the tax exemption of municipal debt. The chapter then covers the demand for municipal securities, and highlights the market segmentation that results from different state income tax systems.
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