The new administration and Congress are working towards an extension of the 2017 Tax Cuts and Jobs Act (TCJA), the bulk of which expires at the end of 2025. In late February, the House passed a spending bill (H. Con. Res. 119-4) to enable the extension, provided that Congress also identifies $2 trillion in spending reductions. Cutting that much spending will be a challenge.
Another way to offset the cost of extending the TCJA is through the closure of tax “loopholes.” One such loophole under discussion is the exemption of interest on qualified state and local bonds from federal income taxation. The House Ways and Means Committee estimated that the elimination of the exemption will raise up to $250 billion in additional income tax revenue over the upcoming 10 years.
The elimination of the exemption must be carefully considered because, according to the Public Finance Network (PFN), state and local governments are responsible for 90 percent of all public infrastructure spending and over 80 percent of that spending is financed with tax-exempt bonds. Non-profit organizations and multi-family housing providers also rely on tax-exempt bond financing to finance the construction and renovation of facilities such as hospitals, schools, and affordable housing developments.
Purchasers of qualified bonds are willing to accept a lower return due to the tax exemption of the interest. According to the PFN, market data from 2023 shows tax-exempt municipal bonds reduced state and local borrowing costs by 210 basis points, for example, from 6.1 percent to 4 percent. Elimination of the tax exemption would correspondingly raise borrowing costs by more than $823 billion over the next 10 years. These costs will have to be passed on and are estimated to produce more than a $6,500 tax and rate increase for every American household and business.
Tax-exempt municipal bonds provide stable, reliable investments for an important market—retail investors aged 65 and over. Not only do the investors enjoy the tax benefit, but they also have the comfort of historically low default rates and a seasoned, well-regulated market. If the elimination of the exemption is applied to outstanding bonds, there may be enormous market turmoil as fixed-rate bond holders seek instruments with higher coupons.
The arguments for elimination of the exemption include the advantages tax-exempt bonds enjoy over conventional taxable instruments, which may foster overinvestment in public infrastructure projects. According to the Tax Policy Center, the exemption is also viewed as (i) an inefficient subsidy in that the cost to the U.S. Treasury exceeds the benefits enjoyed by state and local governmental issuers and (ii) disproportionately favoring wealthy individuals, who hold most of the bonds outstanding.
Congress last seriously considered eliminating the exemption when it enacted the TCJA. We will continue to monitor the deliberations.
