You may have heard that key provisions of the 2017 Tax Cuts and Jobs Act (TCJA), also known as the "Trump tax cuts," are set to expire at the end of this year. As a result, Republican lawmakers, currently controlling both chambers of the U.S. Congress, are exploring several controversial proposals to pay for what the Congressional Budget Office (CBO) estimates could be $4.5 trillion in extended tax breaks over ten years.
One option reportedly on the table that could affect millions of U.S. households? Eliminating or limiting the tax exemption on municipal bond interest.
This potential change is raising alarm in the $4 trillion municipal bond market, long considered a cornerstone of U.S. public finance and a popular investment choice for many so-called “regular” investors.
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Is this the last year muni bond interest will be nontaxable at the federal level? Read on to learn more.
Municipal bond tax exemption on the chopping block?
Municipal bonds, also known as "munis" (debt securities issued by state and local governments to finance public projects), typically offer tax-exempt interest income at the federal level. (That interest is also often tax-free at the state level if your state issues the bond.)
So, the federal government forgoes anywhere from $32 to $42 billion annually in estimated revenue due to the muni bond interest exemption.
Stephen Moore, an informal economic adviser to former President Donald Trump, has been vocal about taxing municipal bond interest.
Moore argues that targeting muni bonds aligns with Republican goals of "widening the tax base" and is "politically feasible" because it primarily affects high-income investors who benefit most from the exemption.
"You want to impose taxes on the wealthy? This is an effective method," Moore told Bloomberg.
Moore has additionally suggested that eliminating or capping the exemption could help offset the cost of extending TCJA provisions without increasing overall tax rates.
And while lawmakers are discussing eliminating the tax exemption, other approaches are reportedly under consideration. For example:
- Targeting Specific Bond Types: The tax preference could be changed for specific categories of bonds, like private activity bonds and Build America Bonds.
- Phased Approach: A gradual reduction of the tax exemption to mitigate market disruption.
Meanwhile, U.S. House Budget Committee Republicans have identified this move as a potential revenue source, estimating it could generate approximately $250 billion over ten years.
Impact on muni investors
The potential impacts of any change to how bond interest is taxed could be far-reaching. The municipal bond market is a core component of financing public infrastructure projects across the United States.
On its website, industry coalition group Municipal Bonds for America (MBFA) states, “Today, roughly 75% of the infrastructure in the country is financed by municipal bonds, accounting for 4 million miles of roads, 16,000 airports, and 900,00 miles of water pipelines.”
Municipal bonds have also long been a popular choice for individual investors looking for stable, tax-advantaged income. Data show that individual households own approximately 66% of outstanding municipal securities.
According to MBFA, muni bonds are predominantly held by individual investors, with about 72% owned directly or through mutual funds. The majority of these individual investors are over 65 years old.
The organization also points out on its website that a notable portion (reportedly about 40%) of municipal bond interest is paid to households earning less than $200,000 a year. Still, as MBFA reports, businesses, including insurance companies and banks, own approximately a quarter of muni bonds.
That widespread ownership underscores the potential impact of tax changes on taxpayers who may rely on these investments for stable, tax-advantaged income.
If muni bond interest becomes taxable, investors would need to include the interest in their taxable income. That would likely increase their federal, state, and local tax liabilities and push some individuals into higher tax brackets, increasing their overall tax burden.
On a related point, Brian Egan, chief policy officer for the National Association of Bond Lawyers noted to the National Association of Countires (NACo): ”Municipal bonds have long been seen as a way for Americans to conservatively pay for their retirement, to get tax certainty later in life. Taking away this tool would create yet another disruption on the investor side.”
Additionally, if the tax exemption were eliminated, bond advocates argue the consequences could be far-reaching, including:
1. Higher Borrowing Costs: Removing the tax exemption would likely increase borrowing costs for state and local governments by as much as 35% to 40%, according to some estimates.
2. Market Disruption: A potential sell-off could further increase yields and borrowing costs and strain state and local government finances.
3. Infrastructure Impact: Increased borrowing costs could hurt funding for critical infrastructure projects.
The Tax Policy Center reports that repealing the muni bond tax exemption could lead to less investment in state and local infrastructure. “Alternatively, state and local governments would need to increase local taxes or cut spending to maintain infrastructure spending,” the TPC states.
Not surprisingly, several industry groups are mobilizing to protect the tax-exempt status of municipal bonds. For example, the BDA, the National Association of Bond Lawyers (NABL), and the Public Finance Network (PFN) have each launched advocacy efforts to preserve the exemption.
The Government Finance Officers Association’s (GFOA) policy statement on tax-exempt status of bonds includes the longstanding industry principle that “no federal tax should be imposed, either directly or indirectly, on the interest paid on state and local government obligations issued to provide services to the public.”
Trump Tax Plan and bond tax exemption: Bottom line
As Congress debates how to fund its next round of tax cuts, municipal bond interest remains "in play," as Moore reportedly described it to Bloomberg.
However, it’s important to note that no specific legislation has been introduced yet in Congress to repeal the muni tax exemption.
Right now, congressional Republicans are working to advance President Trump’s tax agenda. But key differences between the House of Representatives and the U.S. Senate (both of which are led by Republicans) appear to be creating hurdles.
Both chambers are racing to finalize their plans, with major TCJA provisions set to expire at the end of 2025, and the debt limit at risk as early as this summer.
- The House passed a sweeping budget resolution (“one big beautiful bill,” according to President Trump) that includes about $4.5 trillion in tax cuts over the next decade.
- The Senate plan is smaller in scope, with a $340 billion price tag.
Still, for the millions of American households invested in municipal bonds, the coming months will be a time to stay informed and consider how potential changes might affect their financial futures.
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