Do Tax-Exempt Bonds Really Subsidize Municipal Capital?
NBER Working Paper No. 3835
We argue that the tax-exempt status of municipal bonds provides little or no subsidy to capital investment by communities. Instead, the tax exemption simply provides arbitrage opportunities to high and low tax bracket individuals while leaving individuals in intermediate tax brackets essentially unaffected. We also argue that the revenue cost of the tax exemption is much less than traditionally thought due to the portfolio rebalancing that would occur if the tax exemption were eliminated. Finally, we note that the only way to prevent all municipal arbitrage possibilities would be to pass through municipal interest income and payments to residents for tax purposes.
Published: National Tax Journal, Volume XLIV, No. 4, Part 1, December 1991. Cambridge: The MIT Press. Available through NBER.