NCPA - National Center for Policy Analysis

Effect on Tax-exempt Bonds of Eliminating The Dividends Tax

April 21, 2003

State and local officials are concerned about President Bush's proposals to eliminate double taxation of dividends, reduce the capital gains tax on retained earnings and expand tax-favored savings accounts.

These proposals would give most savings the same federal tax treatment now accorded to tax exempt bonds issued by state and local governments. Officials worry that if bonds lost their current tax advantage relative to other assets, they would have to pay higher interest rates on borrowed funds.

However, the historical data show no sign that improving, or threatening to improve, the tax treatment of other assets raises interest rates on state and local securities.

  • From early 1986, when President Reagan proposed lowering income tax rates, to January 1987, when the first rate reduction took effect, tax exempt bond yields fell 1.42 percentage points and corporate bond yields fell 1.69 points.
  • The spread between them fell from 1.97 to 1.70, but interest rates on both went down.
  • As the full tax cut took hold, in January 1988, the tax exempt rate was 0.39 percentage points below its January 1986 level, while the corporate rate was 0.17 points below its January 1986 level.

The spread was actually wider than before the tax cut. There was no surge in state and local borrowing costs.

In the mid-1990s, the Flat Tax plan proposed by then-Majority Leader Dick Armey (R-Texas) would have ended the tax differential between government bonds and other forms of saving. Although the measure was under active discussion, the prospect of passage had no apparent effect on bonds:

  • From October 1994 to December 1996, tax exempt bond yields fell about 1.07 percentage points, while taxable corporate bond yields fell 1.75.
  • The spread narrowed from 2.05 to 1.37, but both rates went down.

Since President Bush announced his proposals last fall, the tax exempt bond rate has hardly moved, and the corporate bond rate has fallen slightly.

Source: Stephen J. Entin, "President Bush's Saving Proposals and the States," IRET Congressional Advisory No. 149, March 7, 2003, Institute for Research on the Economics of Taxation.


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