We detail the developments surrounding the municipal bond tax exemption and provide context through a volatile and uncertain market.
Municipal bonds (munis) have been used in the United States for more than two centuries to fund the majority of education, healthcare, infrastructure, and public safety ventures. By purchasing munis, investors lend money to the municipality in exchange for regular interest payments, usually paid semi-annually, and the repayment of their original investment, or principal.
What’s at Risk?
Generally referred to as tax-exempt bonds. Interest is often excluded from gross income for federal income tax purposes and is also usually exempt from state and local income taxes if the investor resides in the state where the bond was issued. However, some municipal bonds are not tax-exempt.
Since 1913, Section 103 of the federal tax code has excluded income earned on state and local bonds. Nevertheless, the muni tax exemption has returned to the limelight in recent months as the 2017 Tax Cuts and Jobs Act is set to expire at the end of this year. There have been rumblings from Republican lawmakers, who currently control both chambers of the U.S. Congress, on the potential elimination of the federal tax exclusion for interest earned on munis. A Ways and Means Committee estimates this reversal of policy could raise $250 billion over the next 10 years. Investors should be aware of the intricacies of this potential change to protect their portfolios and financial security.
Why Investors Buy Municipal Bonds
The tax-exempt status has been a cornerstone of the municipal bond market, fostering its growth and stability. For individual investors, municipal bonds have long represented an oasis of stability, offering consistent tax-free income. While the prospective change might raise concerns for investors, it’s vital to understand the fundamental role this exemption plays in municipal financing.
Steady and Predictable Income
Muni bonds are popular with investors as a way to earn a steady paycheck from their portfolios. Most municipal bonds pay interest twice a year, so barring default, you know precisely how much to expect and when you’ll receive it.
Local Investment
Municipal entities of all types, including states, cities, counties, and towns, use munis to fund day-to-day operations and capital projects such as schools, highways, and sewer systems.
Safe But with Risk
Munis are generally considered “safe” investments because default rates have historically been lower than those of comparable corporate bonds. However, GO bonds issued by municipalities such as cities and counties can default. Additionally, some municipal bonds, such as high-yield ones, may be risky.
According to the National League of Cities, tax-exempt bonds have financed more than 75% of the U.S. infrastructure. And munis are projected to finance $3 trillion in new infrastructure investments by 2031. According to Municipal Bonds for America, about 72% of muni bonds are owned by individual investors directly or through mutual funds. The IRS said that 60% of muni investors are over 65 years old.
Muni Facts
With an estimated 80,000 issuers, the municipal bond market contains nearly 10 times the number of listed equities worldwide and over one million individual securities.1 The default rate for investment-grade municipal bonds was 0.09%, compared to 2.23% for investment-grade corporate bonds.2
1. Municipal Securities Rulemaking Board, Municipal Market by the Numbers, September 30, 2024.
2. Moody’s, U.S. Municipal Bond Defaults and Recoveries, 1970–2022.
How the Tax Exemption Fuels Growth
State and local governments rely on muni bonds to finance long-term capital investments such as transportation infrastructure and public buildings. The municipal bond market is massive: By the end of 2024, its total valuation was estimated at $4.2 trillion, with new issuances of over $500 billion.[1]
U.S. Municipal Bond Issuance
Source: SIFMA Research
The tax-exempt status of municipal bonds is not merely a perk for investors; it’s the lifeblood of infrastructure development across the nation. Since the early 20th century, this exemption has enabled states and local governments to raise capital at significantly lower costs. By offering tax-free interest, municipalities can attract investors and fund essential projects such as roads, bridges, schools, and hospitals. This system directly benefits communities, ensuring the availability of vital public services, and the cost-effectiveness of municipal financing is directly tied to this tax advantage.
The Factors Against Radical Change
The potential elimination of the municipal bond tax exemption poses a complex challenge for investors and policymakers alike, and there are several obstacles. Besides political opposition from state and local governments and numerous industry groups, the adverse economic consequences (including reduced infrastructure investment and increased borrowing costs) would be extensive. Lawmakers are likely to explore alternative revenue sources and tax reforms before resorting to eliminating a tax exemption that is so critical to local financing. There are also discussions that the federal government does not have the constitutional right to tax state revenues.
If the tax exemption were eliminated, muni bond advocates believe the consequences could be far-reaching, including:
- Higher Borrowing Costs
Removing the tax exemption would likely increase borrowing costs for state and local governments by as much as 35% to 40%, according to the Government Finance Officers Association - Market Volatility/Disruption
A potential sell-off could further increase yields and borrowing costs and strain state and local government finances. The transition would disrupt a market that has historically provided stability - Reduced Infrastructure Investment
The elimination of the tax exemption could inevitably lead to a decline in infrastructure investment, with essential projects being delayed or canceled - Strain on Local Budgets
The financial strain on local governments would be substantial, potentially leading to cuts in essential services or increases in local taxes.
Investors would face lower after-tax returns on municipal bonds, diminishing their appeal relative to taxable alternatives. Many investors, particularly those in higher tax brackets, might reallocate their portfolios towards other investment vehicles, such as corporate bonds or equities. The elimination would result in a higher tax burden for investors who rely on municipal bond income for retirement or other financial needs.
Strategic Considerations
In light of the potential elimination of the tax exemption, investors should consider the following strategic considerations:
- Proactive monitoring can help investors stay ahead of market shifts. Staying informed about legislative developments and policy changes related to municipal bond taxation is crucial for making informed investment decisions.
- Tax planning is also important. Investors should consult tax professionals to assess the potential impact of the elimination of the exemption on their tax situations.
- Seek professional investment advice to assess the potential impact of any changes on your investment strategy.
Key Takeaways
Investors should remain aware but avoid making rash decisions based on speculation. While the future of the tax exemption remains uncertain, investors can take a prudent approach to protect their portfolios. We believe that municipal bonds will remain a relevant investment no matter what comes next. Diversifying across various asset classes, including taxable and tax-exempt bonds, equities, and real estate, is essential for mitigating risk and optimizing risk-adjusted returns.
[1] Source: SIFMA, as of 28 February 2025.
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