State and Local Governments

When first introduced in 1913, the federal income tax excluded the interest income earned by holders of the debt obligations of states and their political subdivisions from taxable income. It was asserted by many that any taxation of this interest income would be unconstitutional because the exemption was protected by the Tenth Amendment and the doctrine of intergovernmental tax immunity. The U.S. Supreme Court rejected this claim of constitutional protection in 1988 in South Carolina v. Baker (485 U.S. 505).

Although the legal basis for the subsidy is statutory rather than constitutional, the subsidy may be justified on economic grounds. Economic theory suggests that certain types of goods and services, such as a street light, will not be provided in the "optimal" amounts by the private sector because some of the benefits are consumed collectively. The nation's welfare can be increased by public provision of these goods and services, some of which are best provided by state or local governments. Certain goods and services provided by state or local governments, however, benefit both residents, who pay local taxes, and nonresidents, who pay minimal if any local taxes. Since state and local taxpayers are likely to be unwilling to provide these services to nonresidents without compensation, it is probable that state and local services will be under provided. In theory, the cost reduction provided by the exemption of interest income compensates state and local taxpayers for benefits provided to nonresidents. This encourages the governments to provide the optimal amount of public services.