Proposed IRS limits on tax-exempt bonds are a welcome step

Ed Lotterman: Real World Economics
Ed Lotterman: Real World Economics

Such is the power of the Internal Revenue Service that its proposed new rules this week limiting the issuance of municipal bonds caused squeals across the nation and, reportedly, one eerie moan from Detroit’s Woodlawn Cemetery.

The squeals came from local officials, particularly those in entities with “economic development” or “port authority” in their titles, as the new rules sharply twisted their knickers. The moan was from the grave of Horace Dodge, an early auto titan.

These irate reactions clearly outweighed murmurs of appreciation from economists. Most in the discipline think the expansion of “municipal bonds” from physical infrastructure to essentially private businesses is abusive and harms economic efficiency.

Don’t count on the new rules surviving intact. Indeed, their stringency may be an opening political gambit. State and local governments have big clout in Washington. And it typifies Mancur Olson’s “logic of collective action” in which a small group, each of whom has much at stake, will out-lobby a much larger group, each of whom has little stake. Expect the final rules to be less strict than those announced.

Opponents of extending tax-free bonds to projects peripheral to core government functions tend to be movement conservatives in the GOP, joined by good-government policy wonks among the Democrats. There is no broad constituency in either party calling for limits. The public focuses more on such bonds as a loophole favoring the rich rather on economic waste. So let’s look at the basics of municipal bonds.

These are bonds issued by state and local governments, historically to finance roads, bridges, schools, sewers and so forth. Interest earned by owners of the bonds is exempt from the federal personal income tax.

One often hears that this exemption is the result of a specific decision by Congress to encourage infrastructure. The reality is more mundane. It traces back to a tradition in English law that one unit of government did not interfere in the fiscal affairs of another one. When the income tax was introduced in 1914, less than 1 percent of households owed anything and state and local bonds were not a major factor in their income. More were held by institutional investors like insurance companies. So exempting this interest from individual taxation was almost an afterthought.

When tax rates soared during World War I, however, the exemption became an important wealth-management tool. That brings us to Mr. Dodge’s wife, Anna Dodge. When he died in 1920, Dodge was one of the richest men in the country, with net worth near $200 million. As a share of U.S. GDP, it was equivalent to $200 billion today.

At his death, Anna was the richest woman in the United States. She sold her shares in Dodge and became a passive investor. Since she was in a high tax bracket, most went into tax-exempt bonds. Surviving her husband by another 50 years and spending little of her annual income, she had tens of millions in annual income by the 1960s and paid no federal income tax.

That fact became public and “Mrs. Horace Dodge” was commonly cited, including on the floor of Congress, as an example of the unfairness of the U.S. tax system. Some say she was the reason Congress established the alternative minimum tax.

Her financial managers were not fools. She did benefit from the exemption. But the benefit was far smaller than people imagined. Because municipal bond interest is tax-exempt at the federal level, the bonds can be sold even paying lower interest. So Mrs. Dodge’s apparent savings in taxes were largely offset because she earned less interest than if she had owned taxable securities. The “loophole” was and is far smaller than people imagine.

The effect of the exemption thus is largely a subsidy to state and local governments rather than a gift to the rich. It does reduce federal revenues, so the rest of us pay marginally more. But as long as the implicit subsidy goes for roads, schools, community centers and water mains that we all use, any extra we pay at the federal level is offset by lower costs at the state and local level. It is relatively fair and any efficiency losses are small.

However, when bonds are issued by a “port authority” to fund commercial buildings or private housing, things get muddled.

Officials running such entities claim increased employment, retail activity and increased real estate and income tax revenues.

The problem is that, as for tax-increment financing and incentive packages offered to bring in factories or sports teams, the result for society as a whole is more shifting the location of economic activity rather than increasing it. If a new office park goes to one municipality instead of another, the first city may win but the second loses. There is no net increase for the state as a whole and certainly not for the nation as a whole. So why favor it with a de facto federal subsidy?

As development agencies become increasingly creative in using tax-exempt bonds to fund essentially private projects, investments become based on skills at playing political games rather than on market-based criteria of return on investment. And once a few municipalities start to play the game, all the rest are faced with a “prisoners’ dilemma.” If the others don’t form their own entities to funnel tax exemptions to essentially private development, their jurisdiction loses new development to ones that do. Resources are wasted.

So IRS action to curb this trend is good news. Whether all specifics in these new rules are prudent is another question. But something needed to be done.

St. Paul economist and writer Edward Lotterman can be reached at