why are municipal bonds tax exempt 
interest earned on state and local bonds has been tax exempt since the introduction of the federal income tax in 1913 initially this was because many people felt the constitution prevented the federal government from taxing this income since then the justification for tax exclusion has been supported by the idea that local infrastructure projects serve the common good and therefore federal tax policy should support those projects 2municipal bonds are not always tax free federal taxes may apply to a municipal bond if the internal revenue service irs does not interpret a project as good for the entire public taxable municipal bonds are rare but they can be issued for projects such as a sports stadium or a pension shortfall the irs can also treat municipal interest income as taxable if a bond is purchased at a significant discount to par value 3a mutual fund composed of tax free bonds is still subject to capital gains tax 4the bottom linethe tax equivalent yield is the return that a taxable bond needs to possess for its yield to equal the yield on a comparable tax exempt bond such as a municipal bond the way a bond s interest income also called coupon payments is taxed varies according to the type of bond and where it s issued coupon payments from a u s treasury bond are free from state and local taxes coupon payments from municipal bonds are also exempt from regular federal income tax 