Working Paper

Debt capacity, tax exemption, and the municipal cost of capital: a reassessment of the new view

Abstract: The Traditional View of municipal investment holds that the federal tax-exemption of interest payments by state and local (municipal) governments provides a capital cost subsidy to municipal investment. Recently a New View has emerged which argues that tax-exemption plays a minor role, if any, in shaping municipal investment decisions. In its simplest version (with municipal debt issued at a constant interest rate), the New View argues that tax-exemption plays a role only for municipalities in which the representative individual has an income tax rate lower than the implicit tax rate on municipal bonds. An extended version of the New View, in which municipal bonds are sold at interest rates which increase with leverage, predicts that all communities will choose tax finance at the margin. Thus, the New View holds that local taxes should be the dominant form of finance for municipal investment at the margin, except perhaps, in communities represented by people with income tax rates at or above the implicit tax rate on municipal bonds. The New View rests on an assumption of unlimited borrowing power with constant interest rates in the taxable bond market. However, virtually all agents face debt capacity limits which prevent them from using taxable debt to finance all capital investment, both private and municipal. This paper examines the implications of debt capacity limits and concludes that when they are effective, all municipalities should treat the municipal bond rate as the marginal cost of funds except those very rare communities in which the representative citizen has both a high income tax rate and an extremely high capacity to borrow in the private debt market. This study also finds that leverage-related interest rates strengthen rather than weaken the case for the Traditional View. In short, we conclude that the New View applies only to communities whose representative citizens are extremely affluent. If less-than-affluent communities choose different mixes of tax and debt finance, the effect is not on the marginal cost of capital or on the volume of municipal investment. Rather, it is on the average cost of capital, and on the distribution of income.

Keywords: Municipal finance;

Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Working Papers

Publication Date: 1995

Number: 95-8