Portfolio Substitution and the Revenue Cost of Exempting State and Local Government Interest Payments from Federal Income Tax

38 Pages Posted: 27 Oct 2008 Last revised: 28 Oct 2008

See all articles by James M. Poterba

James M. Poterba

National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Department of Economics

Arturo Ramirez Verdugo

Protego - Public Finance

Date Written: October 2008

Abstract

This paper explores how alternative assumptions about household portfolio behavior affect estimates of the revenue cost of excluding state and local government interest payments from the federal income tax base. Standard tax expenditure estimates assume that current holders of tax-exempt bonds would replace their holdings of tax-exempt bonds with taxable bonds if the tax exemption were eliminated. We consider a number of alternative possible portfolio responses. Because taxable bonds are among the most heavily taxed assets, assuming that investors holding tax-exempt bonds would otherwise hold taxable bonds yields a larger estimate of the revenue cost of tax exemption than many alternative assumptions. Based on data from the 2004 Survey of Consumer Finances, we estimate that the revenue cost of tax exemption under the "taxable bond substitution hypothesis" is $14.2 billion, compared with $10.1 billion if corporate stock replaces tax-exempt bonds in household portfolios, and $7.9 billion if investors distribute their tax-exempt bond holdings in proportion to the other assets currently in their portfolios. We also explore the revenue effects of capping the dollar amount of tax-exempt interest per tax return and of limiting tax-exempt interest as a fraction of AGI.

Suggested Citation

Poterba, James M. and Ramirez Verdugo, Arturo, Portfolio Substitution and the Revenue Cost of Exempting State and Local Government Interest Payments from Federal Income Tax (October 2008). NBER Working Paper No. w14439. Available at SSRN: https://ssrn.com/abstract=1289673

James M. Poterba (Contact Author)

National Bureau of Economic Research (NBER) ( email )

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Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Arturo Ramirez Verdugo

Protego - Public Finance ( email )

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Mexico, D.F., 11000
Mexico

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