https://crsreports.congress.gov
April 16, 2025
Selected Issues in Tax Reform: Federal Subsidies for Municipal
Bond Interest
The federal tax code includes subsidies for interest income
earned on state and local (municipal) bonds. Municipal
governments issue bonds to investors to finance
investments in exchange for interest payments and the
eventual repayment of principal (the amount borrowed).
Federal bond subsidies have been subject to sustained
legislative interest, including changes enacted by P.L. 115-
97 (often referred to as the Tax Cuts and Jobs Act, or
TCJA) and the Infrastructure Investment and Jobs Act of
2021 (IIJA; P.L. 117-58). This In Focus summarizes the
subsidies provided under current federal law, discusses
changes enacted in recent Congresses, and briefly examines
relevant policy issues.
Summary and Legislative Background
The federal government subsidizes state and local debt
through three policies: (1) all interest income earned from
public purpose bonds is excluded from federal income
taxation; (2) interest income earned from qualified private
activity bonds (PABs) is excluded from federal regular
income taxation; and (3) a tax credit may be claimed on
interest income in lieu of the exclusion in some cases,
though authority to issue new tax credit bonds has expired.
Table 1. Projected Tax Expenditures on Federal Bond
Subsidies, FY2024-FY2028
Billions of dollars
Source: Joint Committee on Taxation, Estimates of Federal Tax
Expenditures for Fiscal Years 2024-2028, JCX-48-24, December 2024.
Table 1 shows Joint Committee on Taxation (JCT)
estimates of the budgetary effects of federal bond subsidies
from FY2024 to FY2028. The federal bond subsidies are
projected to provide a total of $196 billion in benefits over
five years. That annual subsidy represents about 1% of the
current municipal debt stock: the Federal Reserve estimated
that state and local governments had $3.3 trillion in debt
issuances outstanding in the last quarter of 2024.
Tax-Exempt Bonds
Bonds are considered to be for a public purpose if they
satisfy either of two criteria: (1) less than 10% of the
proceeds are used directly or indirectly by a
nongovernmental entity; or (2) less than 10% of the bond
proceeds are secured directly or indirectly by property used
in a trade or business. Bonds that satisfy either test are
called “governmental” bonds and can be issued without
federal restriction. The federal government subsidizes the
cost of governmental bonds by excluding interest income
earned by investors on those bonds from federal income
taxation. The exclusion lowers the cost of debt for state and
local governments by allowing them to borrow at lower
interest rates than would otherwise apply if the interest
income were taxable.
The lower interest rates arise because in most cases
investors will be indifferent between taxable and tax-
exempt bonds of equivalent risk if their after-tax return is
identical. For example, consider a taxpayer in the 37% tax
bracket who seeks to invest in a taxable bond with a 10%
interest rate or a tax-exempt bond with a 6.3% interest rate.
The taxability of the bond with the 10% interest rate makes
the investor’s after-tax income identical to that of the tax-
exempt bond with a 6.3% interest rate. Thus, state and local
governments could raise capital from investors at an interest
cost 3.7 percentage points lower than a borrower issuing
taxable debt.
The direct cost to the federal government of tax-exempt
bonds is the individual and corporate income tax revenue
forgone. In the example above, a taxable bond with a 10%
interest rate would have generated federal tax revenue equal
to 3.7% (37% x 10%) of the bond’s principal value
annually.
Some bonds, called refunding bonds, are issued to replace
outstanding bonds with less favorable terms. There are two
types of refunding bonds: current refunding bonds, which
are redeemed within 90 days of the refunding bond issue
date, and advance refunding bonds, which are issued in
such a way that both the original and refunding bonds are
outstanding longer than 90 days. Only current refunding
bonds are eligible for a federal tax subsidy, as P.L. 115-97
repealed the ability to issue tax-exempt advance refunding
bonds. Refunding bonds may be issued for public or private
purposes.
Qualified Private Activity Bonds
Bonds that fail both public purpose tests are termed private-
activity bonds (PABs) because they provide significant
benefits to private individuals or businesses. These projects
are generally ineligible for tax-exempt financing. However,
activities that fail each test but that Congress considers to
provide both public and private benefits are categorized as
qualified and can be financed with qualified PABs, which
