One element of tax reform being debated as part of a deal to prevent going over the fiscal cliff includes taxing at least a portion of municipal bond interest rates. It would have big implications for Blue America. Exempting state and local government bonds from taxation gives investors an incentive to buy them and reduces the borrowing costs of states and cities. It is one of the federal government's largest tax expenditures, costing about $27 billion a year. In some high tax states, such as California, these bonds are also exempt from local taxation. The main justification for the exemption is that it facilitates the financing of capital projects such as roads and schools.
However, critics argue that it also encourages excessive borrowing. As John Hood argues, "because government bonds have artificially low interest rates, state and local governments end up borrowing more than they otherwise would in order to finance more infrastructure projects than they would otherwise build.... State and local officials already have enough perverse incentives to build themselves bigger houses; they do not need additional enticement to spend every last dime they can get their hands on." In addition, the exemption can crowd out private sector initiatives, as government can claim to do the job cheaper because its debt is less expensive. On the other side, the U.S. Conference of Mayors, headed by Philadelphia's Michael Nutter, is deeply opposed to tinkering with the exemption. Expect heavy inter-government lobbying if the exemption really makes it onto the chopping block.
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