State and Local Governments

The federal government intervenes in the public capital market by granting the debt instruments of state and local governments a unique privilege – the exemption of interest income earned on these bonds from federal income tax. The tax exemption lowers the cost of capital for state and local governments, which should then induce an increase in state and local capital formation. The lower cost of capital arises because in most cases investors would be indifferent between taxable bonds (e.g., corporate bonds) that yield a 10% rate of return before taxes and tax-exempt bonds of equivalent risk that yield a 6.5% return. The taxable bond interest earnings carry a tax liability (35% of the interest income in most cases), making the after-tax return on the two bonds identical at 6.5%. Thus, state and local governments could raise capital from investors at an interest cost 3.5 percentage points (350 basis points) lower than a borrower issuing taxable debt.

Generally, the degree to which tax-exempt debt is favored is measured in a variety of ways. Two are fairly common: the yield spread and the yield ratio. The yield spread is the difference between the interest rate on taxable bonds (corporate bonds or U.S. Treasury bonds) and the interest rate on tax-exempt municipal bonds of equivalent risk. In recent decades, the spread between tax exempt and taxable bonds has declined as underlying interest rates have declined. The greater the yield spread, the greater are the nominal savings to state and local governments as measured by the interest rates they would have to pay if they financed with taxable debt.

The yield ratio (which is an average rate on tax-exempt bonds divided by an average rate on a taxable bond of like term and risk) adjusts the spread for the level of interest rates. A lower ratio implies a greater savings to state and local governments relative to taxable debt. As the ratio approaches one, however, tax-exempt borrowing approaches that of taxable borrowing.

Variation in the cost of state and local borrowing relative to the cost of taxable borrowing arises from changes in the demand for and supply of both tax-exempt and taxable bonds. Demand for tax-exempt bonds depends upon the number of investors, their wealth, statutory tax rates, and alternative investment opportunities. Supply depends upon the desire of the state and local sector for capital facilities and their ability to engage in conduit financing (issuing state or local government bonds and passing the proceeds through to businesses or individuals for their private use). Almost all of the factors which influence demand and supply are affected by federal tax policy and fiscal policy.