What Are Tax Exempt Bonds?
Tax exempt bonds are debt securities issued by state and local governments or their agencies, where the interest income earned by the bondholders is exempt from federal income tax. In many cases, if the investor resides in the state or locality that issued the bond, the interest may also be exempt from state and local taxes, making them "triple tax-exempt." These fixed-income securities are a crucial component of public finance, providing a means for governmental entities to raise capital at a lower cost for various capital projects.
History and Origin
The concept of tax-exempt bonds in the United States dates back to the early 20th century. While municipalities borrowed money long before, the federal tax exemption for municipal bonds was codified with the passage of the Revenue Act of 1913, which established the modern federal income tax. This exemption was based on the principle of "intergovernmental tax immunity," implying that the federal government could not tax the borrowing power of state and local governments. This principle was supported by the Supreme Court's 1895 ruling in Pollock v. Farmers' Loan & Trust Co., which deemed a federal income tax on municipal bond interest unconstitutional. Although this stance was later challenged and effectively overturned by South Carolina v. Baker in 1988, Congress has largely maintained the tax-exempt status of these bonds.6
Key Takeaways
- Tax exempt bonds are issued by state and local governments, with interest income typically free from federal income tax.
- Many tax exempt bonds also offer exemption from state and local taxes if the investor is a resident of the issuing entity.
- They are primarily used by state and local governments to finance public infrastructure and other essential services.
- The tax exemption makes these bonds particularly attractive to investors in higher tax brackets.
- To compare tax exempt bonds with taxable bonds, investors often calculate the taxable equivalent yield.
Formula and Calculation
The primary calculation associated with tax exempt bonds is the taxable equivalent yield (TEY). This formula helps investors compare the returns of a tax-exempt bond to a taxable bond by determining what yield a taxable bond would need to offer to provide the same after-tax return as a tax-exempt bond.
The formula for taxable equivalent yield is:
Where:
- Tax-Exempt Yield is the yield (e.g., yield to maturity or coupon rate) offered by the tax-exempt bond.
- Marginal Tax Rate is the investor's federal marginal income tax rate (expressed as a decimal). For a more precise calculation, state and local marginal tax rates can also be included.
Interpreting the Taxable Equivalent Yield
Interpreting the taxable equivalent yield is crucial for investors, particularly those in higher income brackets, to make informed decisions about their bond investments. A higher taxable equivalent yield indicates a greater advantage for the tax-exempt bond over a comparable taxable bond. For example, if a tax-exempt bond yields 3% and an investor is in the 30% federal tax bracket, the taxable equivalent yield is approximately 4.29%. This means a taxable bond would need to offer a yield of 4.29% to provide the same after-tax return as the 3% tax-exempt bond. Investors can then compare this TEY to actual yields offered by taxable securities to determine which offers a more beneficial after-tax return. This calculation helps optimize portfolio performance by maximizing after-tax investment income.
Hypothetical Example
Consider an investor, Sarah, who is in the 32% federal income tax bracket. She is considering purchasing a municipal bond with a par value of $1,000 and a 3.5% coupon rate, or a corporate bond with a 5% coupon rate. Both bonds have similar credit ratings and maturities.
To determine which bond offers a better after-tax return, Sarah calculates the taxable equivalent yield of the tax-exempt municipal bond:
Taxable Equivalent Yield = 0.035 / (1 - 0.32)
Taxable Equivalent Yield = 0.035 / 0.68
Taxable Equivalent Yield ≈ 0.05147 or 5.147%
This calculation shows that the 3.5% tax-exempt municipal bond is equivalent to a taxable bond yielding approximately 5.147% for Sarah. Since the corporate bond she is considering only offers a 5% yield, the municipal bond provides a slightly better after-tax return for her, even though its nominal coupon rate is lower.
Practical Applications
Tax exempt bonds are widely used by state and local governments for a diverse range of public purposes. These public entities issue municipal bonds to finance a wide array of public works, including the construction of schools, hospitals, roads, bridges, and water and sewer systems. T5hey also fund essential services and ongoing operational needs.
There are primarily two main types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuing government, meaning they are supported by its ability to tax its citizens. Revenue bonds, on the other hand, are secured by the specific revenue generated by the project they finance, such as tolls from a bridge or fees from a water utility. T4he tax-exempt status allows these governmental bodies to borrow at lower interest rates than they would otherwise, which translates into lower costs for taxpayers. According to the City of Alexandria, VA, municipal bonds typically finance long-term investments like public buildings and infrastructure, and their interest rates on tax-exempt bonds are estimated to be significantly lower than taxable bonds. F3urther details on reporting various types of investment income and expenses can be found in IRS Publication 550.
2## Limitations and Criticisms
Despite their benefits, tax exempt bonds face certain limitations and criticisms. One common critique revolves around their efficiency as a federal subsidy. Critics argue that for every dollar of revenue the federal government forgoes due to the exclusion, state and local governments receive less than a dollar in lower borrowing costs. The remainder of this benefit, often referred to as "leakage," is captured by high-income households in the form of higher after-tax returns. S1ome research suggests that the tax-exempt status provides little to no actual subsidy to municipal capital investment, instead creating arbitrage opportunities for individuals across different tax brackets.
Furthermore, the tax-exempt status of municipal bonds can lead to a less transparent subsidy mechanism compared to direct federal grants or subsidies. It can also disproportionately benefit wealthy investors, as the tax savings are more significant for those in higher marginal tax rates. While most municipal bonds offer federal tax exemption, some, like certain "private activity bonds," may be subject to the alternative minimum tax (AMT), which can reduce their tax benefits for some investors. Additionally, the presence of call provisions can introduce reinvestment risk if bonds are redeemed early during periods of declining interest rates.
Tax Exempt Bonds vs. Taxable Bonds
The fundamental difference between tax exempt bonds and taxable bonds lies in the tax treatment of the interest income they generate.
| Feature | Tax Exempt Bonds | Taxable Bonds |
|---|---|---|
| Issuer | State and local governments or their agencies | Corporations, U.S. Treasury, federal agencies |
| Tax Status | Interest is typically exempt from federal income tax; may also be exempt from state/local taxes. | Interest is subject to federal, state, and local income taxes. |
| Purpose | Fund public projects (e.g., infrastructure, schools, hospitals) | Fund corporate operations, federal debt |
| Target Investor | Most attractive to investors in higher tax brackets | Attractive to a wider range of investors |
| Yield (Pre-Tax) | Generally offer lower pre-tax yields due to tax advantage | Generally offer higher pre-tax yields |
Investors compare these two types of bonds by calculating the taxable equivalent yield of the tax-exempt bond to assess which offers a better after-tax return for their specific tax situation. The decision often hinges on an investor's tax bracket and their need for tax-advantaged income.
FAQs
Who benefits most from tax exempt bonds?
Investors in higher tax brackets typically benefit most from tax exempt bonds, as the value of the tax exemption increases with their marginal tax rate. For these individuals, the after-tax return from a tax-exempt bond can be superior to that of a higher-yielding taxable bond.
Are all municipal bonds tax exempt?
No, while most municipal bonds are tax-exempt, not all are. Some municipal bonds, particularly those issued for certain private activities, may be taxable at the federal level or subject to the alternative minimum tax (AMT). Additionally, state and local tax exemption usually only applies if the investor resides in the state or locality where the bond was issued.
What is the risk of investing in tax exempt bonds?
While generally considered lower risk than stocks, tax exempt bonds carry certain risks. These include interest rate risk (bond prices fall when interest rates rise), credit risk (the issuer defaulting on payments, though defaults are rare for municipal bonds), and inflation risk (the purchasing power of fixed payments eroding over time). Some municipal bonds may also have call provisions, allowing the issuer to redeem them before maturity.
Can I buy tax exempt bonds through a mutual fund?
Yes, investors can purchase tax exempt bonds directly or indirectly through specialized municipal bond mutual funds or exchange-traded funds (ETFs). These funds offer diversification and professional management, making them an accessible option for many investors to gain exposure to the tax-exempt bond market.