The role of federal taxation in the supply of municipal bonds: evidence from municipal governments.

This paper considers ways in which federal tax policy affects municipal asset and debt holdings. The tax treatment of municipal bonds and income creates an arbitrage opportunity for communities to issue tax-exempt debt and invest in financial assets. I present evidence that suggests the rules

OVER 50 years ago, the American economist Henry Simons argued that the federal tax exemption for municipal bond interest income was "a flaw of major importance" (1938, p. 172). Since then, economists have argued the merits of this tax expenditure; politicians for the most part have supported the subsidy, arguing that it is an important component of federal support to state and local governments. Additionally, most state and local politicians have argued that there is a Constitutional right to the tax exemption. This latter argument was decisively rejected in 1988 when the United States Supreme Court ruled that state and local governments had no Constitutional right to issue bonds free from federal taxation. For a brief period, municipal bond prices plunged before Congressional leaders assured traders that Congress had no intention of taxing traditional municipal bonds.(1)

This incident illustrates the sensitivity of municipal bond prices to federal taxation. It reflects in main the important influence of federal taxation on the demand for municipal bonds. There is an extensive literature on the influence of federal taxation on the demand for municipal bonds, and Poterba (1989) provides a good introduction to that literature. This paper considers the role of federal taxation in affecting the supply of municipal bonds. There are two important ways in which federal taxation affects supply. First, the tax-exempt nature of most municipal debt creates opportunities for financial arbitrage as municipal governments can borrow at tax-exempt rates and re-invest at taxable rates, thereby earning an arbitrage spread. While this activity is illegal--and has been for over 20 years--enforcement is difficult and opportunities for evasion persist. Empirical evidence presented below suggests that prior to the Tax Reform Act of 1986 (TRA86), this activity occurred at the municipal level and corroborates evidence presented in Metcalf (1990a) for arbitrage activity at the state level.