If you own your home, you receive an incentive to go deeper into debt than you otherwise would if you take advantage of the mortgage interest deduction. Some people act on that incentive by buying more house. Some people extend the terms of their mortgages.
So what happens when we give a tax break to those who earn interest income on debts issued by governments? It means more people offering to buy the debt than normal which means lower interest rates than normal. Lower interest rates for borrowers usually means more borrowing.
The question is this: Why subsidize government borrowing through the tax code? After all, it’s always taxpayers who are liable for bad borrowing decisions by government.
The idea of eliminating tax breaks for municipal bonds is again under consideration in Congress. It has merit.
Here’s why. When the financial crisis struck, it decimated the private bond industry. Tax revenues, meanwhile, declined. Investors, seeking cover, put more money into tax-free bonds. That move into tax-free bonds effectively lowered the price of borrowing for local governments who were also strapped for cash. And in a down economy, making borrowing easier than cutting spending has obvious ramifications for your future tax bills and waste in government.
The idea is worth considering. What’s more, eliminating that tax break can serve two partisan desires. It’s the elimination of a tax break for big investors, something Democrats often like. It also has the benefit of compelling local governments to live within their means even in the short run, an idea attractive to fiscal conservatives.