Municipal Bonds and the Cost of Sovereignty

• John Vandivier
  • tldr:
    • Block grants give money to local governments more efficiently b/c fed govt price discriminates while local governments don't.
    • But, these grants come with political strings. The effect is a trade of money for sovereignty.
    • This process is expected to occur in the long run for political arrangements similar to the U.S.
Example - taken from an exercise in class with the great Prof. Sita Slavov:

Stacy has a federal marginal tax rate of 39.6%. Joe has a federal marginal tax rate of 15%. The market interest rate is 15%.

Stacy's after-tax interest rate on taxed bonds: 9.06% = 15% - (39.6% * 15%)

Joe's after-tax interest rate on taxed bonds: 12.75% = 15% - (15% * 15%)

Policy 1: Municipal bonds are federally taxed. Municipalities pay the market rate (15%): $30 interest paid by local government, $8.19 in revenue for federal government.

Policy 2: Municipal bonds are not taxed. Municipalities pay a flat rate which maximizes bonds sold (12.75%): $25.50 interest paid by local government, $0 revenue by federal government.

Policy change effect (P1 - P2): Local government gains $4.50, but federal government loses $8.19.

There is an incentive not to change policies in the amount of $3.69.

Policy 3: Municipal bonds are not taxed. Municipalities price-discriminate: Local government pays $21.81, $0 revenue by federal government.

Policy change effect (P1 - P3): Local government gains $8.19, but federal government loses $8.19. The municipal government has a motive to chose this method, but the federal government does not. On net, there is no motive to move to this policy.

One problem not revealed in these exercises is the practical problem of price discrimination. The federal government exercises price discrimination more than local governments do. It is unclear whether this is a problem of industry practice, legal restriction, or actual ability.

Because the federal government price discriminates while local governments do not, it is cheaper for local governments to receive block grants than to sell bonds of their own. This creates an incentive for local governments to accept block grants. One problem is that these come with political strings. In effect, local governments grant federal governments increased legal and political power in exchange for money.

In the long run we expect the efficient result to occur. The two possible efficient results are:

  1. Municipalities begin price-discriminating, if possible.
  2. If for some reason it is not possible for municipalities to price-discriminate, or if they become captured to federal incentive lock-in, then they will prefer block grants from the federal government to the provision of tax free bonds.