Should Interest on Federal Securities Be Exempt from State Tax?

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 The stylized model suggests that the exemption should be repealed, allowing market forces to shape the allocation of Treasury securities across investors.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. . . .

Read the full article as an Adobe Acrobat PDF.

Alan D. Viard is a resident Scholar at AEI.

Photo Credit: iStockphoto/Brandon Rose

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About the Author

 

Alan D.
Viard
  • Alan D. Viard is a resident scholar at the American Enterprise Institute (AEI), where he studies federal tax and budget policy.

    Prior to joining AEI, Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also been a visiting scholar at the US Department of the Treasury's Office of Tax Analysis, a senior economist at the White House's Council of Economic Advisers, and a staff economist at the Joint Committee on Taxation of the US Congress. While at AEI, Viard has also taught public finance at Georgetown University’s Public Policy Institute. Earlier in his career, Viard spent time in Japan as a visiting scholar at Osaka University’s Institute of Social and Economic Research.

    A prolific writer, Viard is a frequent contributor to AEI’s “On the Margin” column in Tax Notes and was nominated for Tax Notes’s 2009 Tax Person of the Year. He has also testified before Congress, and his work has been featured in a wide range of publications, including Room for Debate in The New York Times, TheAtlantic.com, Bloomberg, NPR’s Planet Money, and The Hill. Viard is the coauthor of “Progressive Consumption Taxation: The X Tax Revisited” (2012) and “The Real Tax Burden: Beyond Dollars and Cents” (2011), and the editor of “Tax Policy Lessons from the 2000s” (2009).

    Viard received his Ph.D. in economics from Harvard University and a B.A. in economics from Yale University. He also completed the first year of the J.D. program at the University of Chicago Law School, where he qualified for law review and was awarded the Joseph Henry Beale prize for legal research and writing.
  • Phone: 202-419-5202
    Email: aviard@aei.org
  • Assistant Info

    Name: Regan Kuchan
    Phone: 202-862-5903
    Email: regan.kuchan@aei.org

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