University of Chicago and University of Texas Release Policy Brief on Municipal Bond Tax Exemption

The Center for Municipal Finance at the University of Chicago Harris School of Public Policy and the Center on Municipal Capital Markets at the University of Texas have released a new policy brief, “Municipal Bond Tax Exemption: History, Justifications, Criticisms and Consideration of Reforms,” which serves as a resource for policymakers seeking to understand the historical context, economic rationale, and potential policy considerations surrounding the municipal bond tax exemption.

The policy brief is intended to provide a clear and objective foundation for policymakers as they assess potential changes to the tax treatment of municipal bonds. It does not advocate for any specific course of action but instead compiles the best available evidence on the topic to ensure that decision-makers have access to reliable information as they deliberate.

The policy brief was written by Research Professor Justin Marlowe, Director of the Center for Municipal Finance at the University of Chicago, and Associate Professor Martin J. Luby, Director of the Center on Municipal Capital Markets at the University of Texas.

"Over the past several months, policymakers, regulators, and stakeholders have sought greater clarity on the role of tax-exempt municipal bonds in financing critical infrastructure projects," the authors write. "This paper is designed to offer a non-partisan, research-driven overview to support informed decision-making in Congress."

The policy brief presents several key findings, including:

• Municipal Bonds & Infrastructure: U.S. infrastructure is funded through federal, state, and local sources, with municipal bonds playing a key role, backed by federal tax exemptions.
• Market Size: $4.2 trillion in outstanding municipal bonds (~$20,000 per household), financing roads, schools, hospitals, airports, and more.
• Cost Savings for State and Local Government: Federal tax exemption saved state/local governments $714B (2000-2014) and is projected to save $824B in the next decade.
• Additional Costs to Federal Government: Exemption cost the federal government ~$52B in 2024, raising concerns about efficiency, equity, and transparency.
• Small vs. Large Issuers: Most issuers are small and rely on tax exemption; removing it could limit infrastructure investment. Large issuers dominate the market, and capping tax-exempt debt could shift costs to smaller entities.
• Other Policy Implications: Eliminating the exemption without alternative subsidies would shift financial responsibility to state/local governments, effectively creating an unfunded mandate with uneven regional impacts.

Potential reforms discussed in the brief include (1) fully eliminating municipal bond tax exemption; (2) capping the value of municipal bond tax exemption; (3) capping the annual amount of tax-exempt bond issuance per issuer; (4) eliminating the tax exemption for qualified private activity bonds; (5) eliminating municipal bond tax exemption for higher education institutions and large non-profit organizations; (6) replacing municipal bond tax exemption with a direct subsidy bond program; (7) creating a national infrastructure bank as an alternative to a public municipal securities market; and (8) enabling more public-private partnerships.

As members of Congress weigh the implications of modifying or retaining the municipal bond tax exemption, this policy brief provides a factual basis for understanding the trade-offs associated with different policy approaches. The research underscores that while the exemption has played a pivotal role in infrastructure finance, any changes should be considered in light of their broader economic and fiscal impacts.

The brief is CMF’s third major contribution to the ongoing debate about the municipal tax exemption, following a series of 535 individual reports on the municipal bonds’ impact in individual Congressional districts and U.S. states, which has been widely cited in the media viewed more than 10,000 times in just 10 weeks, and an analysis of where municipal bond investors live, based on the Internal Revenue Service’s Statistics of Income Data.

"Given the importance of infrastructure investment to economic growth and community development, it is critical that policymakers have access to high-quality, non-partisan research when considering tax reforms," the authors write. "Our goal is to contribute to a well-informed policy discussion that takes into account both the benefits and the challenges of the current system."

The policy brief, “Municipal Bond Tax Exemption: History, Justifications, Criticisms and Consideration of Reforms,” is available for download at https://munifinance.uchicago.edu/exemption/.

The Center for Municipal Finance, the first-of-its-kind academic center dedicated to the study of the municipal capital markets, looks to improve the quality of life in our communities through better decisions about state and local taxes, spending, borrowing and investing. CMF offers a variety of data products and education opportunities around municipal finance, including and especially the renowned municipal finance concentration within Harris’ Master of Public Policy program.