Tax Break For Muni Bonds On Table

A proposal to limit the amount of municipal bond interest that can be excluded from income is being seriously considered in "fiscal cliff" talks involving Congress and the President.  Currently, all interest from ordinary municipal bonds is excluded from income for income tax purposes, even if millions of dollars of municipal bond interest are received by a taxpayer in a given year.  This is the number one reason that some very high income taxpayers pay no federal income taxes.

The tax exemption is thought to help states and local governments market their bonds, lowering their borrowing costs. But some fiscal analysts say that an undue share of the exemption’s value goes not to local governments, but to the wealthiest bond buyers instead.

While the exclusion was motivated by constitutional federalism concerns, the courts have held that there is no constitutional right to tax free municipal bond interest.  At least to the extent that interest from state and local government debt is taxed no more heavily than interest from ordinary debts, this conclusion, as a constitutional matter, seems sound.

For what it is worth, I favor ending the exclusion for municipal bond interest entirely.  There is no compelling policy reason for the federal government to have an unlimited and indiscriminate subsidy for either the interest income of predominantly high income, wealthy taxpayer, or of state and local debt without regard to the purposes for which it is incurred.

For Democrats, ending this tax break ends a benefit that allows the rich to pay no taxes on their income.  For Republicans, ending this tax break encourages smaller and more fiscally responsible government.  Ending this tax break would be a win-win proposition politically.