Taxable Municipal Bonds: State and Local Governments Confront the Tax-Exempt Limitation Movement

While most state and local governments have adapted to the changes fashioned by the tax limitation movement, they now must confront a less visible yet no less costly movement to limit their traditional source of debt, the tax-exempt municipal bond. With passage of the Tax Reform Act of 1986, Congress placed significant limitations on the use of tax-exempt bonds for private purposes. In 1988, the tax-exempt limitation movement found judicial sanction when the U. S. Supreme Court ruled in South Carolina v. Baker that state and local bonds are not constitutionally protected from federal taxation. As with the tax limitation movement of a decade earlier, issuers of tax-exempt debt must search for alternative sources of capital, including issuing taxable bonds. After tracing the rise of taxable municipal bonds, this article examines the investment market's response to this new source of capital. It finds that if the private-purpose bonds now exempt had been subject to federal taxation, state and local budgets would have incurred 441 million in additional interest payments in 1988 and almost 6 billion in additional payments over the average life of the bonds. The analysis also finds that taxable revenue bonds incur higher interest rates than corporate bonds, indicating some discrimination by investors against this new type of security.