The Federal Tax Exemption of Municipal Bonds: A Vital and Threatened, Yet Largely Ignored Market-based Defense of Federalism

The purpose of this post is to publicize a key defense of federalism that few people have thought about, and that is being eroded under our noses. The explanation is fairly involved, and will use some basic algebra. If you feel really lost as you continue to read, I recommend starting here: http://www.investinginbonds.com/learnmore.asp?catid=8

We live in a complex world, and just as there are hidden threats to our freedom, there are also non-obvious guardians of it. We have a republic, if we can keep it, and understanding the mechanisms of relative fiscal balance between the federal government and the states is key to the survival of our system of limited government. It’s a long read, but I do hope you’ll make the effort.

The existence of this defense against overgrowth of the federal is somewhat accidental, but it is based upon a simple principle; the federal government can’t tax the states and the states can’t tax the federal government. Not all municipal bonds qualify for this federal tax exemption, but the general rule is that the individuals do not have to pay federal income taxes on the interest paid by bonds issued by state and local governments for a public purpose. As a corollary, interest income derived from bonds issued by the federal government is exempt from state and local income taxes. Additionally, state and local governments exempt the interest income derived from bonds issued in their own jurisdiction*.

People generally make investment decisions based upon their expectations of risk-adjusted, AFTER TAX returns. If two entities that both appear to have the same likelihood of repaying a loan want to borrow money for the same period of time, then an investor would prefer to lend to the entity that offered the larger taxable equivalent yield.

For instance, if F = 35% is the highest federal tax bracket, and C = 10.55% is the highest income tax rate in California, then the taxable equivalent yield for a resident of California with other taxable income placing them in highest brackets for both state and federal taxes would be:

For a U.S. government bond yielding 4% à 4%/(1 – C) = 4.4718%

For a California municipal bond yielding 4% à 4%/(1 – F – C) = 7.3462%

So, if the risks associated with lending money to the federal government and to the government of California were the same, then an investor would surely choose to lend to California instead of the federal government if the pre-tax yield were the same for both options. In fact, if the risks were the same, then an investor would be indifferent between lending to California at a rate of approximately 2.4349% and the federal government at 4% because these are identical taxable equivalent yields (2.4349%/(1-F-C) = 4.4718%)

So, given equal risks and equal pre-tax yields, a private citizen of the United States would prefer to lend his capital to state and local governments. The relative preference of private capital to lend to state and local entities means that it should be easier for them than for the federal government to grow their assets under management in order to meet the demands of citizens.

Now, if you’ve looked at the yields on municipal bonds and U.S. Treasuries lately (http://www.bloomberg.com/markets/rates/index.html ), you’re aware that municipal bonds of most maturities and for most issuers are offering higher pre-tax yields than federal debt. In general, this had not been the case for several decades. (This recent Bond Buyer article (http://www.bondbuyer.com/article.html?id=20090803ED4BPK8U ) highlights a few key points. If any readers have access to a Bloomberg Professional terminal, I’d appreciate it if they could post some historical curves of the yield ratio between municipals and treasuries over the past few decades for key maturities such as 2, 5, 10, and 30 years.)

So, at this point, the question you should be asking yourself is this: what went wrong to make municipal bonds start yielding more than treasuries? The transaction costs to buy and sell a municipal bond are higher than for treasuries because the markets are smaller, but it has always been this way. State and local have to pay underwriting fees that the federal government does not in order to issue debt, but this is not a new factor either. There are a lot of contributing reasons related to the disruption of the bond market due to the credit crisis, and many of them may well be alleviated as it abates.

I’d rather focus on reasons that are the fault of poor governance at the state and local level. Far too many state and local governments have used windfall revenues during economic expansions to hire new employees, give raises, and generally incur large unfunded liabilities far in excess of the benefits. If you looked at any of the electoral maps that are detailed down to the precinct level during the last election, then you are probably aware that every major city in the country is “blue”. This results in city governments that are overly friendly to organized labor. Government employee unions have exploited this relationship and extracted massive compensation and benefits packages from state and local governments. In the case of Vallejo, CA, this resulted in a bankruptcy filing.

(Vallejo was paying more than $170,000 annually in total compensation to its average firefighter: http://www.bondbuyer.com/article.html?id=20080507X4H26R3Z) (The top earner at the police department pulled in $435,638! For a listing of all high earners please see: http://www.sfgate.com/webdb/vallejo/ )

Massachusetts is spending $2800/month per family to house homeless people in hotels. (http://www.boston.com/business/articles/2009/09/16/homeless_families_use_of_motels_on_the_rise/ )

Of course, not all instances of government failure are partisan in nature. School districts throughout Pennsylvania have made massively bad bets on interest rate derivatives. The losses in the Keystone State seem to be the result of superintendents overstepping their financial competence. (http://www.bloomberg.com/apps/news?pid=20601109&sid=ay5LDbjbjy6c)

Jefferson County in Alabama also made bad bets on interest rate swaps. In this case though, it appears to be due to bribery in addition to incompetence. (http://www.bloomberg.com/apps/news?sid=aF_f8gLLNvn0&pid=20601109 )

The prior part of the critique of state and local government failures focused upon wasteful spending. Methods of revenue generation are also at fault for high municipal bond yields. Excessively progressive personal income taxes have resulted in the very affluent shouldering huge portions of revenues. The incomes of high earners exhibit more fractional volatility than those of lower income workers with a higher correlation to general economic conditions. For example, unemployment benefits are capped, so higher income workers get a greater pay cut when they lose their jobs. State and local governments that have a variety of broadly based and relatively low taxes enjoy stable revenues.

Our states and cities are laboratories of democracy and people vote with their feet. Many people move around this great nation without much reluctance, but patriotism, language, culture, personal ties, and the lack any other large developed countries with western values and better governance and taxation keep people from leaving the United States. States with excessive spending on welfare find that their most productive residents leave for places like Texas where they can keep the fruits of their labor. Liberals use this as a reason to push for the effective creation of a unitary state. Conservatives understand that this internal migration is an indicator of the limits of the proper role of the state.

Let’s put this simply, the success of federalism depends upon the competence and honest services of local government officials and requires the vigilant participation of the citizens who keep watch on them. Marco Rubio is correct that if we don’t fix the problems in Washington, then it won’t matter what we do on the state and local level, but failures on the local level tempt federal intervention. We cannot withdraw from our local civic duties and expect that an overextended central government will solve our problems.

A government that demonstrates a commitment to limited and transparent spending on projects and services that have a positive return on investment, a lack of onerous regulation that drives away business, and tax codes that result in revenues that are unlikely to collapse in a recession makes for a good credit risk. This is true on a worldwide basis. Here’s the real silver lining. If local governments set their priorities straight, then the perceived risk of investing in municipal bonds will drop, and the ratio of municipal bond yields to those of treasuries will once again be largely set by federal income tax rates. This will directly counteract Barack Obama’s plans to pay for an expansion of federal government through increases on the top tax brackets because high earners will choose to lend their money locally, driving up federal borrowing costs. This is a battle for federalism that we can all win in our own backyards. Let’s get our own houses in order and then let the invisible hand of the markets starve Fedzilla.

* As an aside, many states tax bonds issued by other states, but some do not, and the right of them to do this was upheld in a recent 7-2 Supreme Court decision.

** I previously said that the existence of this defense of federalism is somewhat accidental. States choose not to tax the interest income derived from their own debt, but if they did, they’d pay higher borrowing costs but make up for them with tax receipts, so for the purposes of driving the allocation of private capital between the state and federal governments this tax exemption is rather inconsequential. This might seem like a strange thought, but there’s no reason that federal tax rates ought to be higher than state and local tax rates. If states taxed their own bonds and federal tax rates were lower than state tax rates, then this would cause it to be easier for the federal government than state governments to borrow from U.S. Citizens! But that’s not how things are, and the odds are good that the highest federal income tax rates will be raised in the future.

*** I’m sure that there are other financial gurus out there who will notice I’ve left out a lot of details and glossed over some things. This post isn’t intended to provide personal investing and/or tax advice or to serve as a rigorous introduction to the mathematics of bond markets. I’ve tried to provide just enough detail to show how the interplay of tax laws and market forces provide a relative boost to local government.

**** I plan to write a few more posts on related topics including the trade deficit, quantitative easing, corporate taxes, and a new federal program called Build America Bonds that you may have noticed if you read through the municipal bond primer I linked to at the top of this post.