Who Benefits from Tax-Exempt Bonds? An Application of the Theory of Tax Incidence

This paper develops and applies a conceptual framework to estimate the distribution among income groups of benefits from the federal income tax exemption of interest on state and local bonds. It first reviews the general theory of tax incidence and how it is applied in practice by the Urban-Brookings Tax Policy Center (TPC) and federal agencies. It then applies that framework to the analysis of the effects of the state and local bond exemption, taking account of how the exemption might affect relative returns to different financial instruments and relative costs of private and public sector goods and services. Across a range of possible assumptions, the authors find that the exemption primarily benefits higher income individuals, even though all holders of debt assets benefit from tax exemption, not just holders of municipal debt. The authors also show that the assumption of how state and local government budgets change in the presence of the exemption matters greatly and affects which households benefit from the exemption and by how much.