Why does Congress allow municipal interest payments to be exempted from federal income taxes in the face of a very large chronic deficit in the federal budget, even though no constitutional provision requires that this tax policy continue? The rhetoric of tax exemption is philosophical, appealing to notions of appropriate intergovernmental relations and, in particular, to the doctrine of reciprocal immunity: no level of government should use its taxing authority to impose harm on another level.

But the true force behind tax exemption is that it provides states and local governments with a valuable subsidy, which can be enjoyed at their discretion. This article identifies the problems posed by tax exemption, and assesses some alternatives. It asks whether the results of tax exemption represent an appropriate outcome, and questions whether tax exemption is really necessary to achieve the benefits stated in its favor.