The story today in Bloomberg's about one of the changes to the Revenue Code to finance the new president's projects and actions under consideration in some quarters in Congress surprised me: to delete the exemption of municipal bonds from income taxation. I thought that exemption was sacrosanct.
In fact, in my new article on the history of municipal bankruptcy, focusing on the enactment of the First and Second Municipal Bankruptcy Acts in 1934 and 1937 in response to the huge numbers of defaults on muni bonds in the early Great Depression, I had written in my introduction that the exemption from income tax had been a big driver for muni bond issuance since the first income tax law:
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Municipal bonds had occupied a sacrosanct place in the world of finance for two reasons. First, there had been almost no defaults since the 1870s. Second, under the Seventeenth Amendment, the first income tax in 1913 had exempted municipal-bond interest which “effectively made the federal government a partner with state and local governments” for the building of a vast amount of infrastructure such as highways. So payment defaults of the late twenties and early thirties shocked the bondholding community. Their lawyers’ resort to litigation was reflexive, and more and more insolvent political subdivisions and special taxing districts found themselves as defendants haled into courts in mandamus suits seeking to compel greater tax collections to force payment of bond arrearages.
Such municipalities were “insolvent” within the definitions in the Bankruptcy Act of 1898 (the BA’98) and the general understanding of lawyers and judges of the day, but on the eve of the Depression, that act afforded relief only for individuals, partnerships, and, since 1910, corporations (but specifically excluding banks and insurance companies—and municipal corporations), and only in the forms of court-supervised liquidation of assets in exchange for a discharge of debts or an opportunity to reach an court-enforced composition with creditors. Railroads and a few other firms imbued with some sort of public interest could restructure outside of bankruptcy through the federal-court device of equity receivership ; but while theoretically possible, receiverships for municipalities required a statutory basis and were “rarely available.”