State and Local Bonds Income Tax Exemption – Encouraging Debt, Empowering Cronyism

December 09, 2013

By Akash Chougule

In Americans for Prosperity’s April 2013 Tax Reform comments, we encouraged Congress to phase out state and municipal bond exclusions. Section 103 of the federal tax code exempts from federal taxation state and local bond interest income. Since this income is not federally taxable, bonds are an attractive investment for taxpayers. However, not only does this bring down the cost of borrowing money, therefore encouraging states and municipalities to issue more debt, it also opens up taxpayers to millions of their dollars being subject to cronyism.

According to the US Census Bureau, state and local governments owe $2.9 trillion in debt, and pay $199 billion each year just to service interest on bonds. As AFP wrote in April, “Eliminating the state and local bond interest exclusion would eliminate one of the major causes of our country’s debt crisis,” and also would have meant an additional $26.2 billion in federal revenue in 2011. Not only would eliminating this exemption lead to more responsible governance and greater revenue without higher tax rates, it would also protect taxpayers from millions of their dollars going toward corporate welfare.

While bonds are a necessary financial tool for governments to build facilities and carry out essential functions, too often they are used to fund private enterprise. For example, Kansas Sales Tax Anticipation Revenue bonds siphoned millions of dollars to developers for the Kansas Speedway and Heartland Park Racetrack. According to the Kansas Department of Commerce, the purpose of “STAR bonds,” as they are known, is to “finance the development of major commercial, entertainment, and tourism areas and use the sales tax revenue generated by the development to pay off the bonds.” However, in actuality the bonds are used directly to pay off the developer of the project, thereby using public tax dollars to benefit a private business – the definition of cronyism. Furthermore, neither citizens nor legislators vote on the funding of individual projects.  The legislature only voted on the STAR program as a whole, which they inexplicably voted to extend until 2017.

A similar case took place in Rhode Island, a state whose politics are known for little more than decades of corruption and big government expansion. In 2010, the quasi-public Rhode Island Economic Development Corporation awarded Boston Red Sox hero Curt Schilling $75 million dollars in moral obligation bonds backed by taxpayers to fund “38 Studios,” Schilling’s new video game company. The State of Massachusetts had turned down Schilling’s risky proposition, but Rhode Island offered the money, lured by the prospect of hundreds of new jobs in their struggling economy. While somewhat different than the Kansas case because these particular bonds were subject to federal taxation, they were still exempt from state and local taxation, maintaining the attractiveness of the investment. The company famously went bankrupt, and has left the Ocean State reeling in financial, economic, and legal struggles. Several parties remain under investigation by state and federal authorities.

Tax-exempt bonds incentivize states to incur massive amounts of debt and fund risky investments. Government is a poor decision-maker in the private sector, and corporate welfare is simply unfair. As Kansas Representative Clay Aurand told the Topeka Capital Journal, the government can pour millions into ventures of its choosing, but “there’s a mom and pop store, and nobody notices, and it goes out of business down the road.” Corporate welfare harms taxpayers first by irresponsibly spending their money, but also by negatively affecting the free market by creating an uneven playing field.

Ending tax exemptions for state and local bond interest income, at least on federal income tax, would make investors more wary of purchasing bonds. As Peter Schweizer wrote for Forbes, “Ending the current tax break wouldn’t end the municipal bond market; rather it would raise federal tax revenue while encouraging greater responsibility in local borrowing, since they would now have to offer market rates.” While Americans for Prosperity encourages Congress to enact revenue-neutral reforms, ending these bond exemptions would both simplify the tax code and create a more competitive atmosphere, forcing states and municipalities to be more careful about where they invest and how much debt they incur. Furthermore, it would indeed add billions of dollars to the federal treasury, allowing more room to cut tax rates. Ending federal income tax exemption on state and local bond interest income is a move that would benefit both the government and the taxpayers – a rare phenomenon in today’s fiscal policy.

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