Who Benefits from Muni Bonds? It’s More Complicated Than You Think

By :: October 29th, 2013

Who benefits the most from the tax subsidy for municipal bonds? The easy answer is: Rich people who buy most of the tax-free paper.

That’s true, according to a new analysis by my colleagues at the Tax Policy Center, but the story isn’t quite that simple. If you look more closely, it turns out that others may benefit as well, including investors in taxable debt. And if you dig even deeper, the answer may depend on what state and local governments do with the subsidy from those tax-free bonds.

The paper’s authors, Harvey Galper, Joe Rosenberg, Kim Rueben, and Eric Toder, started with the usual question—who benefits most when you look at after-tax rates of return from tax-exempts?

At first blush, high-income investors benefit more from that exemption than those in lower brackets (top-bracket taxpayers can save 39.6 cents on the dollar while those in the 25 percent bracket may only be able to save 25 cents).

So far so good, but the authors wanted to take a more sophisticated look—a view that goes beyond a simple calculation of the after-tax return on the bonds and looks at broader, real-world consequences.

For instance, what are the effects of tax-exempts on the holders of taxable debt? In the normal course of events, investors accept a lower coupon rate on tax-free munis than on similar taxable bonds. 

In general, high tax-bracket investors prefer tax-exempts, while those in lower tax brackets or with assets in tax-advantaged retirement accounts like 401(k)s prefer higher yielding taxable bonds. Eventually, the after-tax return on both investments reaches an equilibrium, at least for some taxpayers.

But usual models look only at the tax benefit to muni investors without considering the lower pre-tax return they get from tax-exempt paper. By ignoring this implicit tax, they ignore the total benefit of buying munis.

Similarly, old-style models don’t take into account the higher pre-tax returns from taxable bonds. That omission understates the benefit of munis to investors in taxable debt. Thus, while most of the benefit of the tax-exemption goes to high-income investors, lower-income households who hold taxable bonds in their 401(k)s also receive some advantage.

The authors then ask an even more interesting question: How do the uses of tax-exempt bond income by state and local governments affect the distribution of winners and losers? If, for instance, a state uses the money it saves from lower borrowing costs to reduce taxes, the big winners are likely to be high-income households (depending, of course, on the design of the tax cut).

By contrast, if a state pours the funds into new spending, low- and moderate-income households may end up with a bigger benefit than you might think.           

Here’s another example: Say you are a successful business owner who buys muni bonds issued by your local government. Do you come out ahead, net-net, relative to a world of taxable bonds? To answer that question, you not only have to consider your return from the bonds but also the possibility that your business will face increased borrowing costs to attract investors who would otherwise buy tax-free munis.

This paper did not try to answer all these complicated questions. But just by raising them it highlights an important issue: The world is complicated and trying to figure out winners and losers is a lot tougher than simply calculating after-tax income. Sometimes we do that because we don’t have the tools to do more. But it is important to recognize the limitations of that exercise.


  1. Michael Bindner  ::  11:14 pm on October 29th, 2013:

    This question is where a sensativity analysis would be a good idea. Instead of looking at rates and incentives, find out exactly who is issue the bonds (and how much they float) and who is buying them – by tax bracket. We need to take this question beyond incentives into reality. We also need to do the same thing with the federal debt – at the household level. We assume the rich hold it (or at least I do). The question is, do they really?

  2. AMTbuff  ::  1:16 pm on October 30th, 2013:

    I thought it was common knowledge among economists that most of the benefit of this tax exemption flows to the state and local governments who issue the bonds. Why isn’t that simple statement found in the first paragraph of this paper?

    Although it’s admirable that these authors have attempted to estimate the implicit tax paid by muni buyers, the paper’s results are presented in a way that obfuscates the simple truth that muni buyers and buyers of taxable debt end up with approximately the same net return. The distributional effects then depend primarily on what the state and local governments do with the benefit which flowed to them from the federal government. This in turn depends on whether you view the benefit as fungible, with its use being indistinguishable from any other state and local government spending. The paper uses a per-capita government spending model, ignoring the likelihood that the government’s use of the money will be focused toward lower-income people, e.g., for Medicaid.

    It seems to me that this paper attempts to draw conclusions about small percentage differences when the underlying data and assumptions are not sufficiently accurate to allow such inferences.

    I get the impression that in recent years TPC is only interested in distributional analysis whether it’s the most important question to ask or not. I’d like to see some studies of tax efficiency once in a while. This income inequality hobbyhorse is getting old, and it makes TPC appear to be just another left-leaning think tank. TPC has been and could be so much more.

  3. Joel Michael  ::  4:55 pm on October 31st, 2013:

    I think this report provides useful and interesting information – that is, taking into account the implicit tax reduction (the portion of the exemption that does flow through to state and local governments and the beneficiaries of those entities), it provides a reasonable measure of how the exemption’s benefits are distributed. This moves beyond simply assuming (too simplistically) that bondholders are the only beneficiaries.

    On another level, an interesting question that it does not address is the cost effectiveness of the exemption in delivering benefits to state and local governments (and their constituent individual beneficiaries – whether in higher benefits or lower taxes) that are its presumed beneficiaries. Could more benefits be delivered to them through direct spending (e.g., reinstating some version of Build America Bonds) at the same cost, rather than by continuing the exemption? I assume nobody explicitly intends its benefits to go to higher income bondholders by providing higher interest rates than the implicit tax, but the provision has long been recognized to do exactly that. (The report helps to better quantify the distribution of those benefits.) Or maybe one of the exemption’s real purposes is to undercut the progressivity of the nominal rate structure by providing benefits to high bracket bondholders? If not, we could get budget savings by substituting direct spending for the tax exemption – something both political parties in Congress should be able to agree with? Or maybe not; I seem to remember that some member of Congress (former Senator Kyl?) considered Build America Bonds to be a wasteful government spending that should not be renewed, but probably did not hold similar views of the tax exemption. This points out, I think, the classic asymmetrical way that direct spending and tax expenditures are viewed by many politicians.

  4. insurance  ::  8:32 pm on November 18th, 2013:

    I’m suggested this website by way of the step-brother. I am no longer constructive no matter if that put up is usually authored by technique of him when who else realize this kind of correct approximately my own problem. You happen to be extraordinary! Thank you so much!