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Portfolio Substitution and the Revenue Cost of Exempting State and Local Government Interest Payments from Federal Income Tax

  • James M. Poterba
  • Arturo Ramirez Verdugo

This paper explores how alternative assumptions about household portfolio behavior affect estimates of the revenue cost of excluding state and local government interest payments from the federal income tax base. Standard tax expenditure estimates assume that current holders of tax-exempt bonds would replace their holdings of tax-exempt bonds with taxable bonds if the tax exemption were eliminated. We consider a number of alternative possible portfolio responses. Because taxable bonds are among the most heavily taxed assets, assuming that investors holding tax-exempt bonds would otherwise hold taxable bonds yields a larger estimate of the revenue cost of tax exemption than many alternative assumptions. Based on data from the 2004 Survey of Consumer Finances, we estimate that the revenue cost of tax exemption under the "taxable bond substitution hypothesis" is $14.2 billion, compared with $10.1 billion if corporate stock replaces tax-exempt bonds in household portfolios, and $7.9 billion if investors distribute their tax-exempt bond holdings in proportion to the other assets currently in their portfolios. We also explore the revenue effects of capping the dollar amount of tax-exempt interest per tax return and of limiting tax-exempt interest as a fraction of AGI.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14439.

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Date of creation: Oct 2008
Date of revision:
Publication status: published as 108. "Portfolio Substitution and the Revenue Cost of the Federal Income Tax Exemption for State and Local Government Bonds," National Tax Journal 64 (2011), number 2 (part 2), 591-614. (with A. Ramirez Verdugo)
Handle: RePEc:nbr:nberwo:14439
Note: PE
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  1. Roger H. Gordon & Joel Slemrod, 1985. "An Empirical Examination of Municipal Financial Policy," NBER Working Papers 1599, National Bureau of Economic Research, Inc.
  2. Joel Slemrod, 1981. "A General Equilibrium Model of Taxation with Endogenous Financial Behavior," NBER Working Papers 0799, National Bureau of Economic Research, Inc.
  3. Jon Bakija, 2000. "The Effect of Taxes on Portfolio Choice: Evidence from Panel Data Spanning the Tax Reform Act of 1986," Department of Economics Working Papers 2000-05, Department of Economics, Williams College.
  4. Scholz, J.K., 1993. "Tax Progressivity and Household Portfolio: Descriptive Evidence from the Surveys of Consumer Finances," Working papers 9304, Wisconsin Madison - Social Systems.
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  6. Martin Gervais & Manish Pandey, 2005. "Who Cares about Mortgage Interest Deductibility?," University of Western Ontario, Economic Policy Research Institute Working Papers 20059, University of Western Ontario, Economic Policy Research Institute.
  7. Erickson, Merle & Goolsbee, Austan & Maydew, Edward, 2003. "How Prevalent is Tax Arbitrage? Evidence from the Market for Municipal Bonds," National Tax Journal, National Tax Association, vol. 56(1), pages 259-70, March.
  8. Daniel R. Feenberg & James M. Poterba, 1991. "Which Households Own Municipal Bonds? Evidence From Tax Returns," NBER Working Papers 3900, National Bureau of Economic Research, Inc.
  9. Chalmers, John M.R., 2006. "Systematic Risk and the Muni Puzzle," National Tax Journal, National Tax Association, vol. 59(4), pages 833-48, December.
  10. Daniel Feenberg & Elisabeth Coutts, 1993. "An introduction to the TAXSIM model," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 12(1), pages 189-194.
  11. Roger H. Gordon & Gilbert E. Metcalf, 1991. "Do Tax-Exempt Bonds Really Subsidize Municipal Capital?," NBER Working Papers 3835, National Bureau of Economic Research, Inc.
  12. Gordon, Roger H & Slemrod, Joel, 1983. " A General Equilibrium Simulation Study of Subsidies to Municipal Expenditures," Journal of Finance, American Finance Association, vol. 38(2), pages 585-94, May.
  13. James M. Poterba, 1986. "Explaining the Yield Spread between Taxable and Tax-exempt Bonds: The Role of Expected Tax Policy," NBER Chapters, in: Studies in State and Local Public Finance, pages 5-52 National Bureau of Economic Research, Inc.
  14. Merle Erickson & Austan Goolsbee & Edward Maydew, 2002. "How Prevalent is Tax Arbitrage? Evidence from the Market for Municipal Bonds," NBER Working Papers 9105, National Bureau of Economic Research, Inc.
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