The Simpson-Bowles (SB) deficit reduction plan proposes complete elimination of the tax preference. The Congressional Budget Office (CBO) "Revenue Options" report proposes changing the tax exclusion for investors to a direct tax subsidy to issuers . Issuers, such as governments and certain private entities, benefit from lower cost of borrowing and relatively high-income investors benefit from the resulting tax-free income. In particular, the top 10% of all earners realize more than 77% of the total reported tax-exempt interest income. Overview and Background

The impact of changes to the tax treatment of the interest on state and local government debt can be assessed from three perspectives to analyze: the size of the tax expenditure, the distribution of the tax-exempt interest income, and the value of the tax-exemption to issuers. The array of marginal tax rates in the first column of Table 3 are a mix of current law rates and rates as proposed in the President's FY2013 budget. Thus, under the SB plan, interest payments from new bonds issued by state and local governments would be treated like all other income. This option is estimated to increase revenues $142.7 billion over the 2012 to 2021 budget window. Conclusion

Under current law, there is a significant transfer of federal tax revenue to tax-exempt bond issuers and investors. The proposals do differ in the relative impact on investors and issuers. The FY2013 budget proposal to cap the benefit to the 28% tax bracket would be felt relatively equally between issuers and investors and would not address the inefficiency of using tax-exempt bonds to encourage investment in public capital. The SB tax reform plan would eliminate the tax preference thereby eliminating the economic inefficiency generated by the current tax preference, but would also eliminate the relative benefit of tax-exempt bonds for both issuers and investors. The CBO proposal also eliminates the tax preference for investors, but would preserve the issuer preference albeit at a lower level. The economic inefficiency arising from the current tax preference would also be eliminated by the CBO proposal. The CBO proposal can be modified to yield a roughly equivalent subsidy to the current tax-exempt bond preference for issuers.
Under current law, interest income from bonds issued by state and local governments is exempt from federal income taxes. In addition, interest on bonds issued by certain nonprofit entities and authorities is also exempt from federal income taxes. Together, these tax preferences are estimated to generate a federal revenue loss of $309.9 billion over the 2012 to 2016 budget window. Along with this direct "cost," economic theory holds that tax-exempt bonds distort investment decisions (leading to over-investment in this sector). As with many other tax preferences, the income exclusion is being examined as part of fundamental tax reform.
Generally, the tax preference directly benefits two groups: issuers and investors. Issuers, principally state and local governments (but also certain nonprofits and qualified private entities) benefit from a current lower cost of borrowing. Investors, particularly those in the top tax brackets, benefit from mostly tax-free income. In particular, the top 10% of all earners realize more than 77% of the total reported tax-exempt interest income.
This report first explains the tax preference and the distribution of the receipt of tax-exempt interest. An analysis of the impact of several different proposals then follows. Included in this analysis are proposals to (1) cap the benefit at a specific income tax rate (as offered in the FY2013 budget), (2) eliminate the tax preference and lower overall rates (as proposed in the Simpson-Bowles (SB) deficit reduction plan), and (3) change the current tax exclusion for investors to a tax credit (or subsidy) for issuers (as proposed in the Congressional Budget Office (CBO) Revenue Options report). The proposals differ in the relative impact on investors and issuers.
The proposal in the President's FY2013 budget would be felt relatively equally by issuers and investors and would not address the economic inefficiency of using tax-exempt bonds to encourage investment in public capital. The SB tax reform plan would eliminate the tax preference thereby eliminating the economic inefficiency generated by the current tax preference, but would also eliminate the relative benefit of tax-exempt bonds for both issuers and investors. The CBO proposal also eliminates the tax preference for investors, but would preserve the issuer preference albeit at a lower level. The economic inefficiency arising from the current tax preference would also be eliminated by the CBO proposal. The CBO proposal can be modified to yield a roughly equivalent subsidy to the current tax-exempt bond preference for issuers.
This report will be updated as significant new proposals or legislative events warrant.