As of April 2025, the federal legislature is actively discussing potential changes to the tax-exempt status of municipal bonds, a move that could significantly impact public sector financing. This article provides an overview of the current legislative landscape, the potential consequences of altering the tax-exempt status, and the responses from various stakeholders.

Background: The Role of Tax-Exempt Municipal Bonds

Municipal bonds have been a critical part of public infrastructure financing since their interest income was first exempted from federal taxation in 1913. State and local governments—as well as colleges, universities and nonprofits—depend on these bonds to finance critical projects like schools, hospitals, roads, infrastructure and water systems. Because the interest earned on municipal bonds is exempt from federal taxation, their tax-exempt status not only attracts investors seeking favorable after-tax returns but also reduces borrowing costs for issuers by allowing them to offer lower interest rates.

Current Legislative Discussions

In recent months, the House Budget Committee has identified the elimination of the federal tax exclusion for municipal bond interest as a potential revenue source to offset expiring provisions of the 2017 Tax Cuts and Jobs Act (TCJA). Estimates suggest that such a move could raise $250 billion over 10 years.

While no legislation has been enacted yet, the mere discussion has introduced uncertainty into the municipal bond market. In March 2025, municipal bond funds experienced significant outflows as investor confidence was shaken.

Potential Impacts on State and Local Governments

Eliminating the tax-exempt status of municipal bonds could have profound effects on state and local governments:

  • Increased Borrowing Costs: Without the tax exemption, investors would demand higher yields to compensate for the tax liability, leading to increased interest expenses for issuers (i.e., state and local governments).
  • Reduced Infrastructure Investment: Higher borrowing costs could force governments to scale back or delay critical infrastructure projects.
  • Budgetary Pressures: To accommodate higher debt service costs, governments might need to reallocate funds from other areas or consider tax increases.

A report from the Urban Institute & Brookings Institution Tax Policy Center highlights that repealing the exemption could lead to a sell-off in the municipal bond market, further exacerbating borrowing costs.

Stakeholder Responses

Various organizations have voiced concerns over the potential elimination of the tax-exempt status:

Legislative Efforts to Preserve Tax-Exempt Status

In response to these concerns, bipartisan efforts are underway to preserve and even expand the tax-exempt status of municipal bonds:

  • Investing in Our Communities Act (H.R. 1837): Introduced by Reps. David Kustoff (R-TN), Rudy Yakym (R-IN), Gwen Moore (D-WI) and Jimmy Panetta (D-CA), this legislation aims to restore tax-exempt advance refunding for municipal bonds, enabling public utilities to build and maintain critical infrastructure.
  • LOCAL Infrastructure Act (S. 1453): Led by Sens. Roger Wicker (R-MS) and Debbie Stabenow (D-MI), this bill seeks to reinstate the tax-exempt status of advance refunding bonds for state and local governments, a practice that allowed municipalities to refinance debt at lower interest rates before its elimination in 2017.

Conclusion

The federal legislature’s discussions regarding the tax-exempt status of municipal bonds have significant implications for public sector financing. While the aim is to increase federal revenue, the potential consequences for state and local governments—and, by extension, taxpayers—are substantial. As legislative developments unfold, it is crucial for stakeholders to stay informed and engaged to ensure that the financing tools essential for public infrastructure remain viable. If you have questions regarding these legislative developments and the impact they may have on stakeholders, please do not hesitate to contact us.