Originally published Thursday, November 17, 2011 at 4:06 PM

Guest columnist

The federal tax exemption on municipal bonds is worth keeping

Guest columnist Jim McIntire argues against a Times editorial suggesting the federal tax exemption on municipal bonds be eliminated. McIntire, Washington state treasurer, says to do so would eliminate an important tool to infrastructure development across the nation.

Special to The Times

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STATE and local governments have used tax-exempt municipal bonds for more than a century as a low-cost way to finance public infrastructure. This policy is no "loophole." Rather it is an important thread that helps hold our nation together.

The Seattle Times editorial board has argued that the federal tax-exemption on municipal bonds should be eliminated as one way to reduce the federal deficit ["Boost revenue without killing jobs," editorial, Sept. 18]. It argued investors who buy municipal bonds should not receive preference over other lenders nor should local governments be "enticed" to borrow more than they otherwise would.

This argument is both faulty and costly. The fallacy is the notion that municipal bondholders receive significant preferential treatment over other lenders to governments. Yes, the purchasers of tax-free municipal bonds do not pay income tax on their interest payments. However, the interest payments they receive are lower than for taxable bonds, offsetting most of the tax benefits from owning the bonds.

These lower interest costs are passed on to bond issuers — state and local governments and their taxpayers. For the state of Washington, interest rates on tax-exempt bonds backed by the general obligation of the state are about 82 percent of interest rates for state bonds sold on a taxable basis.

If Washington taxpayers were required to pay taxable interest for all of the bonds we issue to finance roads, bridges, schools and ferries, it would result in considerable cost increases for projects large and small. For example, the Highway 520 project is estimated to cost some $4.6 billion, with more than $4 billion expected to be financed with tax-exempt bonds. Forcing the state to use taxable bonds instead would raise the price tag on the project by more than $400 million on a present-value basis.

Of course, the cost of the tax exemption for municipal bonds is recovered through higher federal income-tax rates. State and local governments could ask for more federal subsidies, but rather than having Congress dictate which projects get built, it's far better to have state and local governments set their own priorities and shoulder the bulk of the cost for their investments.

The history of this exemption dates back to 1895, when the Supreme Court held the federal government had no power under the U.S. Constitution to tax interest on municipal bonds under the 10th Amendment. This decision was embedded in the original federal income tax enacted by Congress in 1916, but was overturned by the Court in 1988 in a ruling still questioned by many legal scholars.

Regardless of the legal questions, there are strong reasons for exempting interest on municipal bonds. Like state and local taxes, bonds are a way to finance state and local government activities such as long-term infrastructure investments. Most state and local taxes are deductible from federal taxable income — and all states with income taxes exempt their own bonds from taxation.

These are the costs of maintaining critical state and local functions, and as such, it makes little sense for the federal government to discourage this financing for state and local governments that are the building blocks of our union. State and local governments are not just another "special interest." They provide essential public services without which the federal government would collapse and we would cease to be a union.

Should national policy "entice" state and local governments to invest in their public infrastructure? I believe taxpayers in Washington have a very real interest in good, safe highways and modern schools that will help our economy prosper and thrive. But, our interest cannot be limited to only our own geographic borders. Our ability to stock our shelves and get our goods to market all over the country depend on the quality of the public infrastructure everywhere.

The success of our national economy would be ill-served by underfunded schools and undereducated citizens. This "enticement" helps weave the fabric of a stronger union striving to be more perfect.

Washington state Treasurer James McIntire is president of the Western State Treasurers Association.


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