Although state individual income tax systems adopt various deviations from the federal individual income tax, one deviation is common to all states--an exemption for interest income from Treasury and some other federal obligations. That uniformity reflects a federal mandate prohibiting states from taxing that interest income, even nondiscriminatorily. Surprisingly, that exemption has attracted little political and economic attention, even as the parallel federal tax exemption for municipal bonds has undergone intense scrutiny.
In this article, I analyze the mandated exemption. A stylized model suggests that the exemption distorts portfolio choice and that it imposes a revenue loss on state governments greater than the interest savings it confers on the federal government. The stylized model suggests that the exemption should be repealed, allowing market forces to shape the allocation of Treasury securities across investors.
The conclusion is not certain, however, because the portfolio distortion introduced by the exemption may offset distortions created by features of the federal tax system. In particular, it may counteract the federal tax system's steering of Treasury securities toward tax-exempt investors. It may therefore be a mistake to eliminate the exemption without reforming the rest of the federal tax system.
If the exemption serves any useful role, though, it is a limited and peculiar role attributable to imperfections in the federal tax system. At a minimum, the exemption should be subjected to the critical scrutiny that it has so far avoided. . . .
Alan D. Viard is a resident Scholar at AEI.