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 The stylized model suggests that the exemption should be repealed, allowing market forces to shape the allocation of Treasury securities across investors.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

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Alan D.
Viard

What's new on AEI

Making Ryan's tax plan smarter
image The teacher evaluation confronts the future
image How to reform the US immigration system
image Inversion hysteria
AEI on Facebook
Events Calendar
  • 01
    MON
  • 02
    TUE
  • 03
    WED
  • 04
    THU
  • 05
    FRI
Wednesday, September 03, 2014 | 9:00 a.m. – 10:30 a.m.
From anarchy to Augustus: Lessons on dealing with disorder, from Rome’s first emperor

We invite you to join us for two panel discussions on how Augustus created order from chaos 2,000 years ago, and what makes for durable domestic and international political systems in the 21st century.

Event Registration is Closed
Wednesday, September 03, 2014 | 12:00 p.m. – 1:30 p.m.
Multiple choice: Expanding opportunity through innovation in K–12 education

Please join us for a book launch event and panel discussion about how a marketplace of education options can help today's students succeed in tomorrow's economy. Attendees will receive a complimentary copy of the featured book.

Thursday, September 04, 2014 | 12:00 p.m. – 1:30 p.m.
How conservatives can save the safety net

Please join us for a luncheon event in which our panel will discuss what conservatives can learn from how liberals talk and think about the safety net and where free-market economics, federalism, and social responsibility intersect to lift people out of poverty.

No events scheduled this day.
No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.