Josh Barro is making some good points about tax-free municipal bonds and tax preferences favoring the wealthy:
It doesn’t have to work this way. We can reform subsidies for municipal borrowing so that 100 percent of them actually go to municipalities, and so that municipal issuers have access to a broader bond market than one consisting of domestic corporations and wealthy individuals. We should also question whether we should subsidize municipal borrowing as much as we do.
There is a ready model for reform. For 2009 and 2010, states and municipalities were allowed to issue so-called Build America Bonds. These bonds were taxable, but the federal government made 35 percent of the interest payments. These bonds can be sold to individuals, but are also attractive to investors who can’t take advantage of a tax preference, such as pension funds and foreign entities.
That program gave municipal governments access to a deeper and more liquid bond market. Because essentially any bond-market participant can purchase them, the limited set of buyers who benefit from tax preferences can’t use their special position to claim a portion of the subsidy.
In 2011, Congress let the Build America Bonds program expire but kept traditional tax-free munis. It would be better to do the opposite: Abolish the municipal bond tax preference and allow a direct subsidy for municipal borrowing. Rather than simply resurrecting the Build America program, however, the subsidy structure that was used for it should be tweaked and restricted.