Writer: Leo Price
Editor: Elliot Harvey
As the oldest continually traded financial instrument in America, municipal bonds hold a unique position in the world of finance. Despite their modest reputation as merely the choice asset of retirees, municipal bonds (commonly referred to as “munis”) hold a load-bearing position in the overlapping interests of governments, regular citizens, and institutional finance. With four trillion dollars in outstanding debt, the American municipal bond market ranks as the fourth-largest fixed-income security. Additionally, it is responsible for funding three-quarters of state and local infrastructure, as well as schools, hospitals, and many other socially beneficial projects. Municipal bonds rarely capture public attention beyond high-profile defaults or, for Californians, ubiquitous television ads. Yet these securities touch nearly every aspect of public life, and their ability to fund American infrastructure depends on a little-known tax code provision now under threat from lawmakers.
Source: SIFMA Research
Municipal bonds are debt contracts issued by state and local governments (collectively called municipalities) used to fund infrastructure, schools, utilities, and other public projects. Essentially, governmental agencies are able to raise money outside of taxes by promising to pay the money (called the principal) back in the future with additional interest. They played a substantial role in the development of modern American infrastructure and institutional finance. Even before Wall Street became the world capital of finance, bonds issued to fund the Erie Canal in the early 1800s traded on the floors of the fledgling New York Stock and Exchange Board (eventually renamed the New York Stock Exchange). Munis allowed early investors a way to buy a stake in the economic development of their local communities. Additionally, municipal bonds were attractive to both investors and municipal governments because they were constitutionally exempt from federal income taxation by the landmark 1895 Pollock v. Farmers’ Loan & Trust Co. Supreme Court decision. While the decision itself was overturned by the 16th Amendment in 1913, municipal bonds remained exempt from federal taxation by the 1913 Revenue Act. This “Gift of Congress”, as the exemption is known in the bond industry, remains integral to the ability of governments to fund public projects.
State and local governments typically use three kinds of municipal bonds: general obligation, revenue, and private activity. General obligation bonds are bonds that are serviced by a municipality’s general revenue pool, meaning that the principal and interest paid to bond owners come from taxes. In many states and localities (including California), they require approval in a voter referendum to be issued. For example, the 2024 California Proposition 2 concerned a 10 billion dollar general obligation bond to fund projects for K-12 schools and community colleges.
Revenue bonds are bonds that are serviced by revenue generated from the specific project that they fund. Due to the inherently limited source of funds for service costs, revenue bonds tend to carry a premium relative to general obligation bonds. The University of California system has nearly 30 billion dollars in outstanding debt from revenue bonds that are used to fund research, student housing, medical systems, and other costs.
Finally, private activity bonds (PABs) are issued by municipal governments on behalf of private entities for projects deemed to be in the public interest. Capital-intensive nonprofits like hospitals and airports have an interest in financing large projects in a way that allows them to match their costs with their revenues. Unlike for-profit businesses, they are unable to sell equity (e.g., stocks) to raise large amounts of money in a short period of time. Private activity bonds allow these qualified nonprofit entities to issue municipal bonds with the same tax-exempt advantages as local governments, so long as they go through what is called a state “conduit issuing authority”. However, in order to qualify for state sponsorship, the project under consideration must meet a laundry list of legal conditions. In short, the asset being financed must be a capital project and be under the ownership of the nonprofit once completed. Private business use of the asset cannot exceed 5% of its use, and the time until the bond matures cannot greatly exceed the expected useful life of the asset. The legal status of PABs is somewhat controversial because it allows private organizations the tax-exempt privileges typically granted only to governments.
The debate over the tax-exempt status of municipal bonds is as old as municipal bonds themselves. The Revenue Act of 1913 preserved immunity from taxation by statute, giving the municipal bond industry room to mature into the multi-trillion dollar market it is today. The low default rate of municipal bonds, paired with its tax exemption, attracted investors who wanted the security of treasuries with the yields of corporate bonds. While suggestions of taxation were brought up throughout the 20th century, the relative stability of the market compared to corporate and mortgage-backed bonds gathered less attention from lawmakers. New regulations primarily strengthened SEC and IRS oversight while requiring greater transparency from issuers. In the 21st century, however, increased financialization, high-profile defaults, and mounting federal debt have brought renewed scrutiny to the muni tax exemption.
Deficits in particular have renewed attention to municipal bond exemptions as lawmakers look for new sources of revenue. Public Activity Bonds, in particular, have received attention as a candidate for taxation because of their benefit to private entities. The 2017 budget reconciliation floated eliminating the exempt status for PABs, but this was ultimately removed. More recently, the 2024 budget increased the requirements for a bond to receive PAB status, and the early stages of the “One Big Beautiful Bill” floated the “total elimination of tax-exempt bonds.” While that language was removed in the final bill, Republican think tanks and industry lobbyists continue to fight over the future of bond taxation, leaving a tenuous future for the many projects and governments that rely on munis for the smooth functioning of their government.
The potential elimination of tax-exempt municipal bonds has sparked alarm across the public finance sector. In one account of the budget reconciliation debate, one public finance lawyer jokingly compared removing the tax exemption to the end of the world. While this is certainly exaggerated, limited empirical evidence suggests that most of the tax burden on municipal bonds is passed on to issuers through higher borrowing costs.. One Congressional Budget Office report places this value at 80%. In a fiscal environment where interest rates are near 10-year highs and state governments struggle to fund important services, elevated borrowing costs could significantly impede the fulfillment of good governance. In the private activity sphere, Healthcare Lawyer Benjamin Wilson of Ropes & Gray says he is less concerned about the specific effects of losing the tax exemption. However, in his industry of specialization, he claims that elevated borrowing costs may be “the straw that breaks the camel’s back” in a world of medicaid cuts and hospital bankruptcies.
Graphic By: Melody Shen
Ultimately, the effects of eliminating the tax exemption will come down to the manner of implementation. In other words, if the 80% figure mentioned before holds, the federal government could deliver the same benefits to state and local governments and nonprofits through direct lump sum payments while spending only 80% of what portion of the interest currently left untaxed by Congress. While this transfer would be more efficient in theory, it entirely depends on the volition of federal lawmakers to fund projects as they may see fit. The primary issue with this approach is that it removes a large degree of state independence in funding public projects for the benefit of their constituents. In an era of growing polarization, this may prove to be a severe impediment to funding critical infrastructure projects. It comes down to the public to ensure that the looming elimination of the municipal bond tax-exemption is not realized as the destruction of publicly beneficial government and nonprofit services.
Featured Image by Jakub Żerdzicki on Unsplash
