Money & Finance › Bonds, rates & Treasuries › Bonds: lending money in exchange for interest
Municipal bonds and tax-free interest
· Asset or instrument
Fact, law or dataA rule, statute, definition or measured number.
Munis are bonds issued by states, cities, school districts and public authorities; their interest is usually free of federal income tax.
See it on the Money & Finance map →How it works
The market is about $4 trillion, spread across tens of thousands of issuers. General obligation bonds are backed by an issuer's taxing power; revenue bonds by one project's income, such as tolls, water fees or airport charges. Because interest is usually federally tax-exempt (and often state-exempt for in-state buyers), munis pay lower yields. For a buyer in the 37% bracket, a 3% muni equals a taxable 4.76%. Defaults are rare but real: Detroit in 2013, Puerto Rico from 2015.
Why it matters
They finance most US roads, schools, sewers and hospitals. For high-bracket investors the tax break can make them out-earn taxable bonds after tax.
Think of it like
A GO bond is like a full-recourse loan backed by the whole borrower; a revenue bond is like a non-recourse loan on a single property's cash flow.
Facts, rules and data
Section 103 of the Internal Revenue Code grants the exemption. Issuer disclosures are public on the MSRB's EMMA website. Investors usually get exposure through muni bond funds or ETFs, or individual bonds via a broker.
Debates and risks
The Supreme Court ruled in 1988 that the exemption is not constitutionally protected. Congress has floated limits, including in 2025; so far it has survived.
Connections (3)
▸Municipal bonds and tax-free interest pay interest mostly untaxed by Internal Revenue Service (IRS)Fact, law or data
The connection
Since the first modern income tax law in 1913, interest on state and local bonds has been excluded from federal taxable income, now under Section 103 of the tax code. The IRS polices which bonds qualify and audits issuers that misuse proceeds. Interest on some 'private activity' bonds counts toward the alternative minimum tax.
When and why
Nationwide since 1913; the IRS's Tax Exempt Bonds office reviews issuers, and investors report tax-exempt interest on line 2a of Form 1040.
How we know
Internal Revenue Code Section 103 and the Revenue Act of 1913; IRS audits that can declare bonds taxable when issuers break the rules.
Debates and risks
Supporters say the exemption cheaply funds local infrastructure; critics say it mostly benefits high earners and costs the Treasury tens of billions a year. Congress periodically weighs limits.
▸Municipal bonds and tax-free interest are rated by Credit rating agencies: Moody's, S&P and FitchFact, law or data
The connection
Most munis are rated. Agencies judge general obligation bonds on an issuer's tax base, budget and pension debts, and revenue bonds on a project's cash flow. Higher grades mean lower borrowing costs for the town or authority. Until 2008, many munis bought AAA status with bond insurance, which collapsed when insurers were downgraded.
When and why
The big three rate tens of thousands of issuers. In 2010 Moody's and Fitch recalibrated muni ratings onto the same scale as corporates, raising many.
How we know
Moody's municipal default studies show rated munis default far less often than corporate bonds with the same grade.
Debates and risks
How pension shortfalls and climate risks, such as floods and wildfires, should weigh on ratings is still being worked out.
▸China's bond market, the world's second largest includes huge local-government debt, akin to Municipal bonds and tax-free interestMainstream view
The connection
Since a 2015 budget-law change, Chinese provinces sell 'general' bonds backed by taxes, like US general-obligation munis, and 'special' bonds repaid from project revenue, like revenue bonds; their interest is also income-tax free. Before that, local governments borrowed through financing vehicles (LGFVs), whose debt is now being swapped into official bonds.
When and why
China's provinces and big cities since 2015; a roughly 10 trillion yuan debt-swap program was announced in November 2024.
How solid is the link?
Ministry of Finance data, the amended Budget Law and State Council announcements.
Debates and risks
Whether LGFV debt is truly backed by Beijing, and how much hidden debt remains outside the official figures.