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Ch11.2.pptxTax Exempt Bond Interest
The fundamental economic characteristic about state/local government bonds and some private-activity bonds issued by state and local governments is that the federal government does not tax the interest income received by investors.
Tax Exempt Bond Inerest
However, states may tax the interest.
Typically, state bonds and local bonds from within the state are not taxed, but bonds issued by jurisdictions outside the state are taxed.
State income taxes exempt interest on federal government bonds.
Tax Exempt Bond Interest
State and local tax-exempt bonds are a type of tax-favored investment for lenders.
The decision by the Supreme Court in South Carolina vs Baker (1988) established that the federal government had the right to tax the interest on state/local bonds.
The fact that the federal government does not is an explicit choice to subsidize the investments for which the state/local bonds were issued.
Tax Exempt Bond Interest
The primary effect of he tax exemption is to allow lower interest rates for state and local bonds than similar taxable bonds.
The tax exemption subsidizes state and local governments through lower borrowing costs.
The tax exemption also subsidizes investors in state and local bonds through their higher after-tax returns.
Tax Exempt Bond Interest
Table 11.3: $10,000 face value bond
Tax Exempt Bond Interest
The tax-exempt bond pays an interest of 6% as opposed to 8% on a similar taxable bond; annual interest is $600 or 6% return net of taxes.
The taxable bond return net of taxes depends on the investor’s marginal income tax rate.
The annual interest payment is $800.
The return net of taxes decreases as the marginal tax rate rises.
Tax Exempt Bond Interest
The return to the investor on a taxable bond is (1 – t)r, where t is the marginal tax rate and r is the nominal interest rate.
The marginal tax rate at which an investor gets the same return from a tax-exempt bond and a taxable bond is:
t* = (r – s)/r where is the tax-exempt rate
Investors with marginal tax rates higher than t* will get a higher net return on the tax-exempt bonds even at a lower interest rate.
Tax Exempt Bond Interest
Comparing state and local tax-exempt bonds to comparable taxable Treasury bonds:
Generally, tax-exempt rates are lower than taxable rates.
The yield differential depends on supply/demand conditions each type of bonds.
Reducing federal tax rates has reduced the differential.
The yield differentials between state/local bonds and Treasury bonds is smaller than between state/local and corporate due to risk.
Tax Exempt Bond Interest
Historically, state and local bonds have been purchased by three distinct groups.
Individuals (both directly and through mutual funds); 44% as individuals and 28% through funds
Commercial banks; 12%
Property and casualty insurance companies; 12%
Tax Exempt Bond Interest
The tax exemption for interest on state and local government bonds is an inefficient subsidy for subnational government borrowing costs.
The tax exemption costs the federal government more than $1 of tax revenue for each $1 of interest cost saved by the state and local governments.
For investors with marginal tax rates higher than t*, federal tax savings are larger than the state and local government saving.
Tax Exempt Bond Interest
Table 11.5
| $10,000 Face value bond 6% interest rate on tax exempt bonds 8% interest rate on taxable bonds | ||
| Marginal tax rate | Interest cost saving to state-local government due to tax exemption | Federal income tax saving to investor in state-local bond compared to taxable bond |
| .15 | Not a tax exempt investor | |
| .20 | Not a tax exempt investor | |
| .25 | $200 | $200 |
| .28 | 200 | 224 |
| .32 | 200 | 256 |
| .36 | 200 | 288 |
| .40 | 200 | 320 |
| .50 | 200 | 400 |
Tax Exempt Bond Interest
State and local governments can potentially profit from this differential.
The state and local governments can sell tax-exempt bonds at the lower interest and invest in taxable bonds at the higher interest.
This type of arbitrage is limited by IRS rules.
One type of arbitrage allowed by IRS rule is to borrow money for specific purposes or cash flow even if the necessary funds are on hand.
Tax Exempt Bond Interest
Another source of inefficiency is that by lowering borrowing costs, tax exemption may increase the amount of state and local borrowing.
In the same way, the tax exemption may lead investors to buy more state and local bonds instead of corporate bonds, raising the borrowing costs to private businesses.
Tax Exempt Bond Interest
Federal income tax changes have substantial effects on both the supply of funds in the tax-exempt bond market and on the demand for funds by the state and local governments.
These changes determine both the rate of interest on the tax-exempt bonds and the amount of borrowing by the state and local governments.
Tax Exempt Bond Interest
Figure 11.6
Tax Exempt Bond Interest
For any given interest rate differential between tax-exempt bonds and taxable bonds, a reduction in the federal marginal tax rate will reduce the supply of loanable funds to the tax-exempt market.
More investors will find their after-tax returns on taxable bonds exceed the tax-exempt returns.
This shift in supply raises the tax-exempt interest rate and reduces borrowing.
Tax Exempt Bond Interest
Changes in the tax treatment of alternative tax-favored investments can also affect the market for state and local bonds.
If the federal government expands the opportunity to take advantage of alternative investments that have special tax treatment, the state and local governments will see a decrease in the supply of loanable funds.
Tax Exempt Bond Interest
State and local governments have found tax-exempt bonds an attractive way to attempt to subsidize private investment for the purpose of stimulating economic development.
There appears to be no cost to the state or local government in contrast to direct expenditures or tax breaks.
Tax Exempt Bond Interest
If the individual state or local governments believe that the cost of private purpose bonds is imposed nationwide on all federal income tax payers, then each government believes that part of their economic development costs are exported to residents of other states or localities by selling private-activity bonds; issue more bonds.
Tax Exempt Bond Interest
Because of the federal tax exemption, the use of state or local government’s tax-exempt borrowing authority fro private purposes creates several economic problems:
The increase in borrowing by state and local governments for these purposes is expected to increase the interest rate on all long-term state and local tax-exempt bonds.
Tax Exempt Bond Interest
Substitution of tax-exempt bonds for taxable debt by individuals and firms reduces the revenue yield of the federal income taxes, necessitating higher federal income taxes, lower federal government expenditures, or larger federal budget deficits.
This revenue cost to the federal government is larger than the interest-cost saving to the borrowers.
Extension of tax-exempt borrowing rights to private entities exacerbates the allocational inefficiency resulting from the extension.
Policy Issues
To avoid these problems, economists have recommended that state and local governments issue taxable bonds with the federal government using a direct subsidy to reduce state and local borrowing costs.
The advantage is that it will cost the federal government $1 for every $1 of subsidy.
States are wary of subsidies because the federal government could decide to change the subsidy formula.
Policy Issues
The capital investment funded by state and local borrowing is important because it generates economic growth.
Is the level quantity or quality of public investment “optimal”?
Is the quantity or quality sufficient to provide the public services desired by the residents?
Does the public infrastructure contribute to economic growth?
Policy Issues
The impact of capital infrastructure can be measured in four ways.
Engineering needs and assessments
Political voting outcomes
Measures of economic returns
Economic estimates of direct productivity impact
Statistical evidence yields mixed results.
Policy Issues
Two other issues have policy implications.
If there are diminishing returns from investment in public infrastructure, then growth in public capital in the past may have had large impacts but additional growth may have much smaller effects.
Growth in local employment or income may not be the objective of public capital investment and may not be desired by the local community.
