Because if they were taxed, municipalities would see their interest rates skyrocket. Having municipal bonds be free of taxation benefits the investor (they don't pay income tax), the municipality (more people will be interested in the bonds, hence lower interest rates), and the citizens of the municipality (their tax rates won't go up as quickly).

Seems like a wealth transfer from municipalities that don't borrow heavily to those that do.

That's true, but you seem to imply that this is a bad thing. It's not. A municipality that does not borrow must either tax its current citizens to raise the money to pay for capital expenditures, or stop investing in infrastructure. Neither option produces vibrant economies, particularly in a country where people are relatively free to move.

Or rely on transfers from the federal government.. As most already do..

Munis are a timebomb, imho.

The entire economy of the world is a time bomb since it is predicated on exponential growth continuing indefinitely into the future. That cannot happen, so sooner or later we need to radically shift gears or we're in for a world of hurt. It's a question of when, not if. But since the current regime has been working for several millennia now, it is hard to make the case that The End is Near. It may or may not be.

>The entire economy of the world is a time bomb since it is predicated on exponential growth continuing indefinitely into the future.

Adding zeros is not that hard. Munis have actual tax bases and actual obligations and those seem out of step in some situations. That muni debt will be mispriced because of tax incentives seems obvious.

Municipalities are in the same spot that Greece or Italy is in. They have debt in a currency they do not issue. They cannot devalue or inflate that debt away. Therefore they have to manage their debt as a corporation or state would, but they are much smaller and less flexible. Bad buy.

It's not like munis are a gift; they are repaid through taxes on the citizens of the city/county/state. TANSTAAFL.

Right, but those citizens are paying less than they otherwise would if the lenders were taxes on the proceeds. That discount could be considered a "gift" from the federal government to both local governments and lenders, whose taxes are lower than they would be if muni income were taxed.

Yes, and that 'gift' comes in the form of higher nominal taxes for everyone else.

I agree. However, I can't see the situation changing anytime soon.

It is the simplest and only way to make them competitive for an investor. Anyone can buy them (that can invest in the U.S. anyways). If you tax them, nobody would buy them (risk versus earnings). To become a competitive and practical choice, and since it is an option for this investment, they make them tax free. Otherwise they would have to increase the interest to an unrealistic amount; at that point there would be no lending option practically. (Yes, investors only buy municipal bonds for the tax free trait to be honest. Not a loophole, just giving your money earlier to the government if you think about it from an opportunity cost perspective.)

Think of it as a way to take money from state and federal taxes and to move them to municipalities etc. It's either that or the government above would have to pick up the slack.