Working Paper: NBER ID: w14439
Authors: James M. Poterba; Arturo Ramirez Verdugo
Abstract: This paper explores how alternative assumptions about household portfolio behavior affect estimates of the revenue cost of excluding state and local government interest payments from the federal income tax base. Standard tax expenditure estimates assume that current holders of tax-exempt bonds would replace their holdings of tax-exempt bonds with taxable bonds if the tax exemption were eliminated. We consider a number of alternative possible portfolio responses. Because taxable bonds are among the most heavily taxed assets, assuming that investors holding tax-exempt bonds would otherwise hold taxable bonds yields a larger estimate of the revenue cost of tax exemption than many alternative assumptions. Based on data from the 2004 Survey of Consumer Finances, we estimate that the revenue cost of tax exemption under the "taxable bond substitution hypothesis" is $14.2 billion, compared with $10.1 billion if corporate stock replaces tax-exempt bonds in household portfolios, and $7.9 billion if investors distribute their tax-exempt bond holdings in proportion to the other assets currently in their portfolios. We also explore the revenue effects of capping the dollar amount of tax-exempt interest per tax return and of limiting tax-exempt interest as a fraction of AGI.
Keywords: Tax Exemption; Household Portfolio Behavior; Revenue Cost
JEL Codes: H24; H7
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tax exemption (H20) | Portfolio structure (G11) |
| Tax exemption (H20) | Revenue implications (H22) |
| Tax-exempt bond holders replacing holdings with taxable bonds (H26) | Revenue cost of approximately $142 billion (H59) |
| Tax-exempt bond holders replacing holdings with corporate stock (G32) | Revenue cost of approximately $101 billion (L93) |
| Tax-exempt bond holders distributing holdings proportionally (H23) | Revenue cost of approximately $79 billion (L93) |
| Households with high marginal tax rates (H31) | Portfolio adjustments (G11) |