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In his autobiography, Calvin Coolidge singled out tax-exempt bonds as a travesty; idiotic, improper, probably immoral, and something which needed to be addressed.

Firmly believing that all the income of the nation had to be treated equally (and that public debt was hostile to liberty) Coolidge decried this special treatment, stating point-blank that it provided a way for the wealthy to hide their income from taxation, made it too easy for local governments to amass debt, and benefited local politicians and the buyers of their bonds all at the expense of the taxpayers who had to cover the interest on the debt.

In Coolidge’s day, the courts had ruled that the Federal government didn’t have the power to tax municipal bonds – cities are incorporated extensions of the states, and therefore not taxable under the separate sovereigns doctrine – the courts gradually changed their minds (taxing interest earned by a bondholder isn’t taxing the state) and now the tax exemption is purely statutory.

The important thing about municipal bonds is something called the taxable equivalent yield. Simply put, it is the interest rate that a taxable bond would have to pay in order to give the bondholder the same amount of money after taxes as they would get from a tax-exempt bond. The higher your marginal tax bracket, the greater the benefit of buying tax-exempt bonds.

With such a benefit to be had, it is little surprise that the municipal bond market is enormous – nearly four trillion dollars. Cities, counties, school districts, special use districts, water districts, and the like can all get access to the market under certain conditions and the tax exemption makes them attractive investments to a large portion of the capital pool.

Here, we can see the real problem; not the class warfare rhetoric, but the perverse incentives that this system breeds. Attracted to the higher relative yields and tax savings, wealthy investors have an incentive to lend their money to governments instead of dropping it into private markets. With such a large and eager investor pool, local governments have the ability to borrow more than they otherwise could. The municipal bond market is worth nearly four trillion dollars.

The problem with big government funded by debt tends to be simple arithmetic. As several California municipalities have shown, cities that have huge payrolls, enormous pension obligations, and massive debts which were run up in the boom times have a nasty tendency to lose their tax base, cut basic services, miss important payments, and declare bankruptcy.

Not a single serious effort has been made to eliminate tax exemptions for municipal bonds, and no politician regardless of party has made a serious attempt to address the situation. Simply put, it serves political ends.

President Obama made a half-hearted push to cap the exemption based on income, but it was pure rhetoric. The “community organizer” in him wasn’t about to ruin the favorite gravy train of local elected officials, and his promise to raise income taxes will further encourage the wealthy to buy tax-exempt municipal bonds. Republicans appear no better though, reacting with a sort of anti-tax reflex, despite the fact that you end up paying higher property taxes in order to provide the untaxed interest income for the bondholders.

With the market for municipal bonds given favorable tax treatment, there might be little to prevent a town from issuing a bond for just about anything. Bond referendum elections are practically defined by light turnout, and those with a stake in the bond’s passage are more likely to cast a vote than the general public.

So, with the reality of bond referenda and the markets distorted by tax policy, we have a dangerous situation; bonds which are easily issued and are eagerly snapped up by investors lured in by the promise of untaxed income, all to fund projects which are politically popular. Add on a large public payroll and an underfunded pension plan, and you have a real problem.

But not to worry. The city or county can build a park, expand a road, and put up a parking garage… that will raise property values and lead to increased revenue to cover the payroll, the pensions, and the interest on the bonds issued to pay for the park, road expansion, and parking garage. So, everything will be perfect. Right?

Oops. Jefferson County, Alabama. Stockton, California. San Bernardino, California. Vallejo, California. Central Falls, Rhode Island. Large debt, large operating costs, and large pension obligations took them all down when the revenues dried up.

The next time you are faced with a bond referendum in your community, remember that the market is distorted. It is easy to issue a bond, and there are plenty of investors ready to sit back and collect tax-free interest payments. Payments funded by your property taxes, water bills, parking fees, etc…

It really is an absurd situation; we can’t reign in the costs of government at any level, because of the necessity for economic development and vital services. To spur growth, cities borrowed money. When revenues dropped, cuts to police, fire, and public works were needed in order to cover the bond interest payments. Because government was simply too important to neglect, it will now be too expensive to afford. Camden, New Jersey is even trying to get rid of its police force entirely.

It is time to do away with this absurd exemption. It encourages investors to channel scarce capital away from the private sector and towards local governments. It enables cities to rack up large debts, and if revenue drops, services are cut to avoid defaulting on the bonds. Coolidge said so eight decades ago. Then again, if Coolidge rose from the grave today, he would get to say “I told you so” a lot.

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