Do we really have to line the pockets of billionaires — and Wall Street banking giants — to help states and localities improve their infrastructures? Of course not. But we do.

The third in an Inequality.Org series on the giant pools of assets in America that produce income not currently subject to taxation.

By Bob Lord

If you own a municipal bond, you pay no federal income tax on the interest income the bond delivers to you. As of December 31, 2011, America’s municipal bond balance totaled over $3.7 trillion. The tax exemption on the interest income from that balance cost the federal treasury an estimated $37 billion in 2012.

Why do we exempt from taxes the income from a pool of assets that represents over 5 percent of our aggregate national wealth? Defenders of the tax exemption for municipal bond interest have traditionally maintained that the exemption benefits state and local governments, not bondholders. To some extent, that’s correct. With the interest on municipal bonds not subject to federal tax, states and localities can in theory attract buyers for their bonds without having to offer as high an interest rate as the market demands for corporate bonds of comparable risk.

That’s because if you sit in the top marginal income tax bracket, as most municipal bond investors do, you’ll willingly invest in a municipal bond that offers you less interest income than a taxable bond of comparable risk — if what you save in taxes at least matches how much more the higher-interest taxable bond puts in your pocket.

So if the top marginal federal income tax rate stands at 40 percent and a corporate bond of comparable risk has a market interest rate of 5 percent, a state or one of its subdivisions should be able to find investors for bonds that pay interest at only 3 percent.

But theory, in the real world, has some problems. First, as the New York Times recently reported, some municipal bond offerings — the so-called private activity bonds — finance private development projects. The benefit from the tax exemption these bonds carry goes to private developers, not state and local governments. Among the projects financed through private activity bonds: the Goldman Sachs headquarters in Lower Manhattan, an edifice financed with $1.6 billion of tax-exempt bond proceeds.

Overall, the Bipartisan Policy Center estimates, private activity bonds overall will cost taxpayers $50 billion over the next decade.

The second, and more fundamental, problem: The rationalization for the municipal bond interest exemption assumes we have one bond market. In the real world, we have two markets, one for taxable bonds and one for tax-exempt bonds. These two markets attract entirely different groups of investors.

The taxable bond market — corporate bonds, mortgage-backed bonds, and treasury securities — dwarfs the tax-exempt bond market in size. The players that dominate this taxable bond market? We’re talking pension plans, IRAs, 401(k) plans, foreign investors, banks, and insurance companies.

Some of these players, like pension funds, don’t face taxes on their earnings. Others, like banks and insurance companies, pay taxes on their bond interest earnings at quite low rates. How can banks and insurance companies end up paying taxes on their interest income at these low rates? These taxable entities only face taxes on the interest income they receive that causes their gross income to exceed deductible expenses.

Think of it this way: For each staffer a bank employs at a cost of $50,000, the bank can hold a $1 million taxable bond paying interest at 5 percent and not incur a tax burden.

The tax-exempt bond market, on the other hand, primarily attracts wealthy individuals, taxpayers whose incomes place them in the top federal income tax brackets. These individuals invest in municipal bonds either directly or through mutual funds.

To be sure, the two bond markets do have some overlap. Banks and insurance companies, for instance, do invest in tax-exempt bonds. But the semi-separateness of the markets tends to narrow the spread between tax-exempt and taxable bond interest rates.

Here’s how this dynamic works. If the market rate on taxable bonds momentarily increases, purchasers of municipal bonds have an incentive to move into taxable bonds. They’ll get a better return on these taxables, even after they pay the taxes due on the interest income.

The issuers of municipal bonds have to react to this market reality if they want to sell bonds. They have to offer an interest rate high enough to keep municipal bond investors from fleeing. The end result? The interest-rate spread between taxable and municipal bonds remains modest.

On the other hand, if the market interest rate for taxable bonds momentarily decreases, the great majority of taxable bond purchasers have no incentive to move into the municipal bond market. After all, they’re not paying any or much tax on their interest income anyhow. Municipal bond issuers, if they want to attract corporate bond investors, have to keep offering attractive interest rates.

As a result, the spread between the market interest rate on municipal bonds and the market interest rate on taxable bonds winds up to be narrower than the spread needed to equalize the after-tax return to top-bracket individuals.

Another factor also narrows the interest-rate spread between taxable and municipal bonds. The market for municipals includes some individuals who don’t sit in the top tax brackets. These individuals don’t benefit as much from the municipal bond tax exemption as wealthier individuals. They’re looking for bonds that pay interest at a rate as close as possible to the rates taxable bonds offer. If they can’t find municipals with these rates, they’ll flee the municipal market. To satisfy these less wealthy individual investors, to keep them from fleeing, municipal bond issuers have to keep their interest rates closer to the rates paid on taxable bonds.

All these market dynamics wind up creating a situation where tax-exempt bonds will often hand wealthy individuals a substantially higher return than the after-tax return on taxable bonds. These wealthy taxpayers, in short, get a windfall.

How much of the revenue loss from the tax-exemption for municipal bond interest goes to this windfall for high-income taxpayers? The Center for American Progress recently estimated that windfalls for the wealthy make up 20 percent of the $37 billion annual revenue loss from the tax-exemption for municipal bond interest.

That’s a giveaway of $7.4 billion per year, or $74 billion over the next decade, to our wealthiest taxpayers. But this $74 billion does not include the cost to taxpayers of the exemption for private activity bonds. That sum brings the total cost to taxpayers of the municipal bond tax exemption tens of billions higher.

Yes, most of the benefit from the municipal bond tax exemption flows to state and local governments. But the same benefit could be delivered to state and local governments through a direct federal subsidy of a portion of their interest expense.

A subsidy along these lines would leave states and local governments in the same position, fiscally, as they find themselves in under the current system, without conferring an undeserved multi-billion dollar windfall upon wealthy taxpayers, developers, and folks like our friends at Goldman Sachs.

Read the first article in this series: Retirement Vehicle or Giveaway to the Rich?

The second article in this series: Looting the Treasury to Benefit Big Insurance

Bob Lord, a veteran tax lawyer and former congressional candidate, practices and blogs in Phoenix, Arizona.