Bond interest income tax exemptions

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Bond interest income tax exemptions are policies that allow the reduction of taxable income, thus providing an incentive for investors to purchase government securities instead of private securities. These income tax exemptions on bonds enable taxpayers to subtract an amount of money received from interest on bonds from their total income, thus reducing their federal, state, and/or local tax liability. Bond interest income tax exemptions are applied to interest earned on municipal bonds (bonds used to finance state and local government operations). The lower interest rates on these bonds decreases a government's cost of borrowing which increases a government's ability to provide public capital goods. This policy is widely used by municipalities. It should be noted that the bond interest tax exemption does not apply to any capital gains or losses on the sale of a bond- it only applies to any interest earned while the owner of such a bond.




A local government is struggling to find funds to build a bridge. The existing bridge which connects two islands is old, dilapidated, and does not have a pedestrian walkway. Local lawmakers believe that another bridge is needed for the people on both islands. Interest rates in the market is high and the transportation department does not enough resources to fund the entire project. Residents have been urging the government to build a second bridge for years, as they are tired of the vehicle congestion and have concerns about the viability of the existing bridge. In order to borrow money to fund this project, the government issues bonds with a lower interest rate than private securities; however, in exchange for lower interest rates, bond-holders (island residents) are able to exempt income received from interest from their tax liability. This incentive encourages investors to buy these bonds, which enables the government to borrow even more funds to funds much needed infrastructure projects for the islands.



Tradeoffs of implementing this policy may include:

  1. Interest earned on tax-exempt bonds will be lower than interest earned on regular bonds. This is a trade-off for bond-holders.
  2. Potential loss of tax revenue for federal, state, and local governments.
  3. Greater oversight by the federal government to ensure that tax-exempt bonds are used strictly for public purposes.
  4. More stringent rules and regulations for issuers of these bonds.
  5. Higher-income bond-holders benefit more than lower-income bond-holders, thus creating a regressive tax system
Compatibility Assessment

Compatibility Assessment.png

If answered yes, the following questions indicate superior conditions under which the policy is more likely to be appropriate:

  1. Is the federal government seeking ways to provide subsidies to state and local governments?
  2. Are state and local governments seeking funding for capital investment projects?
  3. Are governments looking for ways to decrease their cost of borrowing?
  4. Would loss of tax revenue have a minimal impact on the government?
  5. Are individuals interested in holding bonds issued by state and local governments?
  6. Is the government not concerned with implementing a regressive tax system?


The following questions should be considered when determining how to implement this policy:

  1. Will any restrictions be placed on who can hold tax-exempt bonds?
  2. What financial needs is the government anticipating for the future?
  3. Does the government have the resources and ability to regulate issuers of these bonds?
  4. Would bond-holders be exempt from all taxes, regardless of the issuer of the bond?
  5. How much tax revenue can the government expect to loose as a result of these bonds?







  • Electeds - State and Provincial Executives. Assumption: Bond interest income tax exemptions will be supported by state and local governments as it reduces their cost of borrowing. In essence, these income-tax exemptions on the bonds provide a subsidy for state and local governments. However, fiscally conservative lawmakers may not be in favor of these tax exemptions because of its ability to reduce tax revenue. [5]
  • Labor Unions - Civil Service. Assumption: Taxpayers will support this policy whenever it decreases their tax liability. [6]







  1. Congressional Research Service Tax-Exempt Bonds: A Description of State and Local Government Debt
  2. New York Bonds
  3. City of Chicago Issues Bonds
  4. New York City Municipal Water FInance Authority
  5. National Tax Journal Municipal Debt: What Does it Buy and Who Benefits?
  6. National Tax Journal Municipal Debt: What Does it Buy and Who Benefits?
  7. National Tax Journal Portfolion Substitution and the Revenue Costs of the Federal Income Tax Exemption For State and Local Government Bonds
  8. Municipal Tax Journal To Tax or Not to Tax: Lessons from the Build America Bond Program about Optimal Federal Tax Policy for Municipal Bonds
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