Such is the power of the Internal Revenue Service that its issuance of proposed new rules this week limiting the issuance of municipal bonds caused thousands of 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 regs sharply twisted their knickers. The moan was from the grave of Horace Dodge, early auto industry titan and co-founder of the Dodge auto and truck company.
The irate reaction of those who issue such bonds clearly outweighed the murmurs of appreciation from economists. Most in the discipline think that the expansion of the rubric of “municipal bond” from traditional physical infrastructure to what is essentially private business development is abusive and harms economic efficiency.
Don’t count on the new rules surviving intact, however. Indeed, their unexpected stringency may only be an opening gambit in a political battle. State and local government have lots of clout in Washington. And it is a classic example of 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 whose members individually have little at stake. Expect the final rules to be less strict than the ones announced.
Opponents of the extension of tax-free status to bonds funding projects increasingly peripheral to state and local government functions tend to be movement conservatives in the GOP. They are joined by some good-government policy wonks among the Democrats, but there is no broad constituency in either party calling for limits on such bonds. Any beef among the public focuses more on such bonds as a loophole favoring the rich rather than as a source of 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 were jacked up during World War I, however, the exemption became an important wealth-management tool. That brings us to Mr. Dodge, or rather his wife, Anna Cotton Dodge. When he died in 1920 of the same “Spanish flu” that killed my grandmother, Dodge was one of the richest men in the country. His net worth was near $200 million. That might sound like small potatoes a century later, but as a share of the whole country’s GDP, it was equivalent to $200 billion today.
At his death, his wife was the richest woman in the United States. She cashed out her shares in Dodge and became a passive investor. Since she was in a high tax bracket, most went into tax-exempt bonds. She survived her husband by another half-century and spent only a fraction of her annual interest income, so by the 1960s she had tens of millions of dollars in annual income and paid no federal income tax.
Somehow that fact became public knowledge 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 assert she was the reason Congress established the alternative minimum tax.
Mrs. Dodge’s financial managers were not fools. She did benefit from the exemption. But the benefit was far smaller than most people imagined. Because municipal bond interest is tax-exempt at the federal level, these bonds can be sold even if they pay a lower interest rate. So Mrs. Dodge’s apparent savings in taxes were largely offset by the fact that she had less interest to begin with than if she had owned taxable securities. The “loophole” was and is far smaller than most people imagine.
The effect of the municipal bond tax exemption thus is largely a subsidy to state and local governments rather than a federal gift to the rich. This exemption does reduce federal revenues, so the rest of us do have to may 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 some “port authority” to fund the construction of commercial buildings or privately owned housing, things get muddled.
The officials running such entities point to increased employment, retail activity and, perhaps in the long run, increased real estate and income tax revenues to local and state coffers.
The problem is that, as for tax-increment financing and the incentive packages offered to bring in auto factories or football teams, the result for society as a whole is more about shifting the location of economic activity rather than increasing it. If a new office park goes into a site on the northeast corner of St Paul instead of Woodbury, 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 more and more creative in using tax-exempt bonds to fund what are largely private projects, investment decisions 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 city or state loses new development to the ones that do. Resources are wasted.
So IRS action to curb this trend is good news. Whether all the specifics of these new rules are prudent is another question. But something needed to be done.