The Purpose and Power of Municipal Bonds

If not for the fact that municipal bonds are exempt from federal income tax, they would likely be about as popular as buttermilk at a college keg party. For example, high quality munis with maturities of five years out were recently yielding an average of 3.75 percent. Five-year Treasuries, meanwhile, are currently yielding 4.75 percent — about one-quarter more the return.

Keep in mind that Treasuries aren’t exactly world famous for their high returns. And while the munis carry some (limited) risk, the Treasuries do not. But of course, munis are tax-exempt.

Why is that? Because in 1895, the Supremes (nine guys in black robes, not the lady singers) decided on a case involving “intergovernmental tax immunity.” In essence, they ruled that the federal government had no right to mess with any local government’s efforts to raise money. And the Supremes determined that taxing local bonds would, in fact, be a form of messing. From that point on, interest on municipal bonds has been largely untouched by the IRS.

When anyone in Washington is ever inclined to challenge that 1895 ruling (oh, yes, it does happen from time to time), he or she never gets very far. That’s because the tax-exempt status of munis allows local governments, such as your township, to issue bonds that carry very modest interest rates.

If local governments across the United States couldn’t issue those bonds — couldn’t get those relatively cheap loans — we’d probably start seeing potholes in the street as big as Rhode Island. A drying up of cheap loans might mean a drying up of ports; bridges and tunnels might not get built; and construction of new schools and low-income housing projects might come to a crawl.

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