Blog of the Century

Meet “Dirty Dozen” Tax Break #5: Exemption of Interest on Municipal Bonds

Blog Post by: Benjamin Landy, on December 14, 2012

In 2002, The Century Foundation convened the Working Group on Tax Expenditures to examine and propose reforms to the tax code. The resulting report, Bad Breaks All Around, identifies twelve tax breaks with little or no economic justification. These "dirty dozen" are no less ripe for the chopping block a decade later, as Congress finally takes up the task of simplifying the tax code. Follow along at Blog of the Century and on the "Dirty Dozen" expenditures homepage as we reintroduce each of the "dirty dozen" and explain why it's long past time to eliminate these costly tax breaks.

As Washington hurtles toward the $607 billion wall of austerity policies known as the "fiscal cliff," policymakers are struggling to agree on which tax breaks and corporate loopholes to close as part of a larger deal to avert an economic recession in 2013 while reducing the budget deficit in the long term.

One possibility that is receiving increased bipartisan support is to limit the exemption of interest on state and local bonds—one of the "dirty dozen" tax breaks that TCF's 2002 Working Group on Tax Expenditures suggested eliminating over a decade ago:

Individuals and corporations that lend money to states and localities pay no federal income tax on the interest they earn. This allows states and cities to pay reduced interest rates. But the money that state and local governments save in lower interest payments is considerably less than the cost of the tax break to the federal government—which is expected to be $142 billion over the next five years [2003-2007].

Although the average interest rate on municipal bonds is nearly three percentage points lower today than it was when Bad Breaks All Around was published in 2002, their tax-exempt status remains a major source of lost revenue for the federal government. According to the Congressional Joint Committee on Taxation, ending the tax exemption for interest on all newly issued municipal bonds would save $124.4 billion over the next ten years.

Another possibility would be to limit or end the exemption for interest on these bonds only for high income Americans—a proposal supported by the Obama administration and many Democrats in Congress. In 2002, Bad Breaks authors Eric Toder, Bernard Wasow and Michael Ettlinger calculated that more than 80 percent of the tax break for municipal bonds goes to those with incomes in excess of $100,000. That percentage is almost certainly higher today, as the wealthy continue to derive an ever-greater percentage of their income from capital gains.

 

Learn more about the "Dirty Dozen" tax breaks here.