Federal Support for the Municipal Bond Markets
November 10, 2021
Federal Support for the Municipal Bond Markets
Introduction
federal tax preference. However, a federal income tax
Municipal bonds are debt securities issued by state, city,
exemption is extended to certain bonds—qualified private
county, and other nonfederal government agencies to pay
activity bonds (QPABs)—issued for private purposes
for capital projects, such as highways, airports, sewers,
explicitly listed in federal statute (26 U.S.C. §141). QPABs
bridges, schools, hospitals, and other public goods for
are designed to support projects with a significant
residents. The municipal bond market consists of more than
nongovernmental presence yet still serve a public benefit
an estimated 1.5 million types of bond issuances from more
(e.g., a privately built toll road that eases highway
than an estimated 55,000 issuers. The U.S. market had a
congestion).
total of $3.2 trillion municipal bonds outstanding, at the end
of June 2021, roughly 4.3% higher than the amount
Tax Credit Bonds (TCBs)
outstanding at the end of 2019 (the last quarter before the
The third preference is a tax credit attached to certain bonds
economic recession accompanying the COVID-19 crisis).
that may be claimed in lieu of a federal tax exemption. For
these tax credit bonds (TCBs), rather than a federal tax
This In Focus summarizes the federal tax and regulatory
exemption on interest income earned, the investor receives
treatments of municipal bonds, summarizes recent
a tax credit, a direct payment that is proportional to a TCB’s
legislative proposals to modify certain treatments, and
face value. The value of the tax credit does not depend on
discusses possible impacts that current treatments may have
the investor’s marginal income tax rate, as is the case with
on the demand and supply of municipal bonds.
tax-exempt bonds and QPABs. The authority to issue TCBs
was repealed by P.L. 115-97, though previously issued
Tax Preferences
TCBs still outstanding receive federal tax credits.
Tax preferences for municipal bonds subsidize state and
local government borrowing costs for capital projects.
Legislative Proposals
Preferential tax treatment may compensate state and local
Legislative proposals have been introduced every year that
taxpayers for benefits provided to nonresidents. Debt
would change the tax treatment of municipal bonds. Stand-
issuances to fund long-term projects may also better align
alone bills in recent Congresses would revive TCBs (e.g., S.
the financial burden with the timing of benefits, thus
1308 and S. 1676), modify the list of activities eligible for
allowing for more predictable state and local financial
QPABs (e.g., H.R. 1396 and S. 1499), and adjust the
planning.
definition of public purpose activities eligible for tax-
exempt bonds (e.g., H.R. 606 and S. 1242, 116th Cong.).
The federal government subsidizes municipal debt
issuances via three types of tax preferences: (1) a federal
Modifications to the tax treatment of municipal bonds were
tax exemption on interest income for public purpose bonds,
also included in the large infrastructure proposals in 2021.
(2) the same tax exemption for selected bonds issued for
H.R. 3684, the Infrastructure Investment and Jobs Act,
private purposes, and (3) a federal tax credit offered in lieu
includes language that would expand the activities eligible
of a tax exemption for bonds supporting certain activities.
for QPAB financing and increase the total amount of
By increasing the investor’s interest income net of taxes,
funding available for certain purposes. Additionally, in
these subsidies allow state and local governments to sell
September 2021, the House Ways and Means Committee
bonds at lower interest rates while remaining competitive
marked up language for H.R. 5376—the Build Back Better
with comparable bonds without a federal tax preference
Act—that would reinstate TCB issuance authority and
(“taxable” bonds).
establish a new TCB for infrastructure projects, allow for
advance refunding of tax-exempt bonds, and make a
Tax-Exempt Bonds
number of modifications to QPAB activity. More recent
All interest income earned by an investor holding a bond
versions of H.R. 5376 have not included bond preference
issued for a public purpose, as defined in the federal tax
modifications. For more on the bond proposals in H.R.
code, is exempt from federal income taxation. Public
5376, see CRS Report R46923, Tax Provisions in the
purpose bonds generally meet either of the following
“Build Back Better Act:” The House Ways and Means
criteria: (1) less than 10% of the proceeds are used directly
Committee’s Legislative Recommendations.
or indirectly by a private (nongovernmental) entity, or (2)
less than 10% of the bond proceeds are secured directly or
Market Liquidity and Disclosure Issues
indirectly by property used in a trade or business.
Municipal bonds tend to be most actively traded in the
primary market, the market where they are newly issued.
Qualified Private Activity Bonds (QPABs)
According to the Securities and Exchange Commission
Private purpose bonds are any bonds that fail to meet either
(SEC), one-third of municipal bonds trade once after initial
of the public purpose criteria and generally do not receive a
issuance; the remaining bonds trade two or three times
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Federal Support for the Municipal Bond Markets
during their lifetimes, and 5% of all municipal bonds may
Disclosure Requirements for Private Placements
trade once every 12 years. Bond trading after initial
In 2012, the SEC noticed a rise in the private placement of
issuance, referred to as secondary market trading, occurs
municipal debt to investors. Rather than issue municipals in
between two parties via broker-dealers. (Brokers conduct
public offerings, some municipal borrowers were able to
securities transactions for others and are generally paid a
place debt securities with private market lenders (e.g.,
commission on securities sales. Dealers conduct securities
banks), thus avoiding underwriting and disclosure
transactions for their own accounts. Broker-dealers conduct
compliance costs. In response, the SEC adopted a final rule
securities transactions for other investors and for their own
in August 2018 revising the list of events that require
accounts.) Because retail (i.e., individual) investors largely
dealers to notify the MSRB of a private placement
buy and hold these assets, secondary market trading of
transaction with an aggregate principal amount of $1
municipal bonds is thin, meaning they trade in low volumes
million or more. Because (1) private lenders can
on an irregular basis (as opposed to trading more frequently
subsequently sell recently acquired debt, and (2) some
in large volumes). Consequently, municipals are not
municipalities may have existing bond issuances
considered liquid, meaning they cannot quickly be bought
outstanding, the disclosure of privately placed municipal
or sold in exchange for cash.
debt obligations allows prospective investors to better
evaluate financial risks linked to the issuers.
Additionally, dealer markups, the commission paid to
broker-dealers to facilitate municipal trades, may be
Cumulative Impact of Federal Efforts
excessive if retail investors have information disadvantages.
Economic analysis of federal efforts to support the
Unlike broker-dealers, retail investors are less likely to have
municipal bond markets would consider improvements in
access to electronic pricing information about past
information dissemination, liquidity, and competitiveness.
transactions. Efforts to increase market transparency,
Such improvements may depend on whether these efforts
therefore, may enhance liquidity and increase the overall
generate reinforcing or offsetting incentive effects.
willingness to hold (and trade) municipal bonds.
Federal tax preferences may increase the appeal of
Disclosure Requirements for Market Transactions
municipal bond investments with lower returns relative
Although federal securities financial disclosure laws do not
to other comparable (bond) investments. Also, if
apply to state and local governments, the Municipal
investors anticipate paying higher markups to purchase
Securities Rulemaking Board (MSRB), was created by the
municipals or selling at deep discounts due to market
Securities Act Amendments of 1975 (P.L. 94-29, 89 Stat.
liquidity issues, the tax preferences may also be seen as
97) to promote fairness and transparency in the municipal
abating these transactions costs. Hence, tax preferences
securities markets. The MSRB is a self-regulatory
may complement efforts to improve market liquidity.
organization that establishes trading rules in the municipal
bond market for its members, who are required to register
Alternatively, the need for municipal bond tax
with the MSRB. MSRB members consist of all municipal
preferences to attract funds to the market may decrease
broker-dealers as well as municipal advisors who earn fees
if enhanced disclosures can reduce market transactions
for advisory services. Because the MSRB does not have
costs. Furthermore, some municipal investments may be
enforcement authority, its rules are approved by the SEC
attractive investments even in the absence of federal tax
and enforced primarily by the Financial Industry
preferences because of their historically infrequent
Regulatory Authority, which is another self-regulatory
default experiences. The MSRB reports a 0.10% 10-year
organization.
(2010-2019) cumulative default rate for municipals
compared to 2.25% for investment grade corporate
The MSRB Rule G-14 requires dealers to submit
bonds over the same period. Hence, whether federal tax
transaction data 15 minutes after execution of a municipal
preferences encourage greater investments in municipal
securities trade, with limited exceptions. Municipal bond
bonds or reward investors who already favor these
prices are frequently determined by observing past trades of
investments is unclear.
municipal securities that arguably share similar
characteristics, which has become easier for retail investors
Knowledge of dealer markup pricing does not provide
since launch of the MSRB’s Electronic Municipal Market
information about the likely performance of issuers’
Access website. Also, the MSRB Rule G-15 prescribes
cash flows during unanticipated events (e.g., a severe
certain uniform transaction settlement procedures and
recession), which arguably may be a better indicator of
requires dealers to provide customers with written
municipal investment risks. Hence, greater disclosure
confirmations of transactions, which contain information
requirements may reduce markups and result in price
about dealer markups and mark-downs.
improvements for some transactions, but compliance
may increase issuance costs—particularly for small
Furthermore, the SEC’s Rule 15c2-12 requires municipal
issuers—possibly reducing bonds supplied to market.
bond underwriters to obtain official documentation to
confirm that issuers are providing the MSRB and other
Grant A. Driessen, Specialist in Public Finance
regulatory repositories timely financial information and
Darryl E. Getter, Specialist in Financial Economics
disclosures of certain events relevant to their bond
issuances. Underwriters must also obtain official
IF11969
documentation to confirm that issuers have in place
continuing disclosure agreements.
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Federal Support for the Municipal Bond Markets
Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to
congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.
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https://crsreports.congress.gov | IF11969 · VERSION 1 · NEW