WASHINGTON — Lower income households benefit more from tax-exempt debt than shown by traditional analyses, researchers at the Urban Institute found.
"In particular, tax-exempt municipal debt is also shown to also benefit low-income households with children by reducing the cost of public education," the researchers said in a paper that appears in the
When the staffs of the Treasury Department Office of Tax Analysis, the Joint Committee on Taxation and the Congressional Budget Office analyze the tax exemption for municipal bonds, they allocate all the benefits of the exemption to holders of the bonds. However, they don't take into consideration all of the "sources of income" effects because they don't look at how interest rate changes caused by the exemption affect holders of both munis and other types of investments, according to the paper.
When the researchers did a simulation looking at the sources of income effects and examined how pre-tax and post-tax income flows are affected by the introduction of the tax exemption, they found that while the net benefit of the exemption as a percentage of income is highest for individuals and households in the top quintile of an expanded measure of income, those in the lower four quintiles also benefit from the exemption. This is because the exemption for munis leads to an increase in the interest rates on taxable bonds, so people who hold taxable bonds also benefit from the tax-exemption for munis.
Also, traditional estimates of the benefits of the muni exemption don't factor in the "uses of income" effects, or how the exemption impacts the relative prices of public and private goods and services, the researchers said. The exemption for munis and the corresponding increase in taxable interest rates lead to an increase in the borrowing costs for the private sector and the federal government and a decrease in state and local governments' cost of providing some services.
The paper's authors quantified the effects of the higher cost of private and federal borrowing and the lower cost for providing state and local services, and then distributed the relative price effects across income groups. The higher prices for private goods and services were distributed in proportion to private consumption by income group. The lower costs for state and local services were distributed based on the income groups' consumptions of the services financed by munis. For example, the benefits of spending on K-12 education were allocated to households based on their number of children under 18, and the benefits of spending on transportation and utilities was allocated to households based on measure of household spending on those items.
The researchers found that individuals and households in the bottom two quintiles of income has benefits from additional public spending that offset the increase in private-sector prices. However, those in the top two quintiles had larger burdens from higher private-sector prices than benefits from additional public goods.
Estimates of how individuals and households benefit from the tax exemption differ significantly between the approach that government offices take when they calculate the benefits and the researchers' estimates that take into account effects of both sources and uses. Particularly, across income levels, households with children benefit more from the exemption under the researchers' approach because the researchers considered the benefits of capital spending for schools.
Households with at least one elderly tax filer benefited more from the exemption under the new method in the lower quintiles but more under the traditional method in the upper quintiles. Under the researchers' method, the elderly benefited from higher interest rates on taxable securities, but at the upper end were affected by the higher cost of private goods and the fact that they sacrificed some pre-tax returns by holding tax-exempt debt, according to Harvey Galper, a visiting fellow at Urban and one of the authors of the paper.
The other authors are Kim Rueben, a senior fellow at Urban's Tax Policy Center, Richard Auxier, a public finance researcher at Urban and Amanda Eng, who worked at Urban and is now an economics graduate student at Cornell University. The paper is related to another paper written last year by some of the same authors.
