Revised article published in the National Tax Journal (March 1998).
The traditional view of municipal finance holds that the federal tax-exemption of interest payments by state and local (municipal) governments provides a capital cost subsidy to municipal investment equal to the difference between interest rates on taxable and tax-exempt bonds. Recently, a new view has emerged which argues that tax-exemption plays a minor role, if any, in shaping municipal investment decisions. According to this new view, communities will use tax finance at the margin except in the unusual case where only debt finance is used. Thus, tax-exemption is an intramarginal (lump sum) transfer providing no incentive for municipal investment. This paper concludes that the new view's policy prescriptions rest on implausible assumptions about voters' financial opportunities and costs. In particular, the new view assumes that the decisive voter has unlimited financial assets on which he can draw to finance tax payments. The new view is shown to contain several anomalous results, including unexploited arbitrage profits and the implication that tax-exemption increases the municipal cost of capital. A broadened analysis incorporating leverage-related interest rates and constraints on financial assets and debt restores tax-exemption as a municipal capital-cost subsidy under a wide range of conditions.