State and Local Bonds

Interest paid on bonds issued by state and local governments has never been subject to the federal income tax (although interest on so-called private-purpose bonds is subject to the alternative minimum tax).⁽¹⁾ State and local governments issue bonds to finance capital projects, such as highways, prisons, schools, and sewage treatment plants. Because of their tax-exempt status, the bonds carry a lower interest rate--generally between 20 percent and 25 percent less--than taxable bonds. That rate discount reduces the cost of capital projects for state and local governments and thus effectively subsidizes the construction of public facilities. It also benefits bondholders with higher marginal tax rates than the percentage discount, because it allows them to realize a higher net yield on their investment than they would on taxable bonds with a similar risk profile. However, taxpayers with a marginal tax rate lower than the percentage discount would be worse off than if they had bought (taxable) corporate bonds.

The tax-incentive structure of state and local bonds is most similar to that of Roth IRAs: the tax benefits are realized gradually rather than all at once when the asset is purchased. Unlike Roth IRAs, however, people of all income classes may purchase tax-exempt bonds, and the amount they may purchase is not subject to any dollar cap.