Financing State and Local Investment: Uses and Limitations of the Municipal Bond Market

Table of Contents

• Introduction
• Overview of Municipal Debt
  • What Is Municipal Debt?
  • A Brief History of Municipal Finance in the United States
  • What Are the Uses of Municipal Debt?
• Private Finance and the Municipal Bond Market
• Limitations and Inequities of the Municipal Bond Market
• Responses to Challenges in Municipal Finance

1. Introduction

To build and maintain the infrastructure essential to modern life and economic integration, someone must bear the cost—but who? Decades of confrontation over the federal government’s role and capacity in infrastructure have led states and local governments to fund a steadily rising share of essential infrastructure costs. Nearly 75 percent of infrastructure spending is funded by state and local governments, with 90 percent of that spending “financed with debt, such as municipal bonds.” 

But what is the municipal bond market, and how does it work? This brief provides an overview of the little-discussed market, its uses, its structure, and the challenges it presents to policymakers and the public. Essential to public finances, the municipal bond market remains opaque to many in the general public whom it impacts. Federal funding is in a precarious position, as illustrated by this year’s rescissions to grant programs, phaseout of clean energy tax credits, and government shutdown. As federal expenditures for various public services dwindle, state and local fiscal capabilities may take on heightened relevance. 

While the municipal bond market is a core tool of financing public infrastructure, progressives ought to be attentive to its limitations and adverse consequences. Discussing the preferential tax treatment of municipal bonds, Franklin D. Roosevelt declared that “a fair and effective income tax and a huge perpetual reserve of tax-exempt bonds cannot exist side by side.” Additionally, many scholars have shown how a reliance on private debt markets to finance public infrastructure at the state and local levels has served to entrench existing inequalities and subjected public governance to the interests of private financial actors. 

Section 2 of this paper presents an overview of municipal bonds and the primary uses of municipal debt finance. Section 3 describes the key actors who comprise this market, and Section 4 considers the consequences of this system of finance. Section 5 provides a brief overview of policies that have been proposed or implemented to address the limitations of municipal bond finance. 

2. Overview of Municipal Debt

What Is Municipal Debt?

Among their many unique functions, states and localities are financial actors. Like corporations and the federal government, one of the key ways they finance and manage their expenses is to borrow by issuing debt. This debt is issued through the municipal bond market in two broad types: general obligation bonds and revenue bonds. General obligation bonds are backed by the “full faith and credit” of the issuing entity, meaning that they could be paid back using general tax revenues. State law typically requires a ballot referendum for municipalities to issue bonds of this type, in many cases requiring a threshold of two-thirds of voters to approve. Alternatively, a municipality can issue revenue bonds, which are paid back through specified tax sources or rate fees paid by the users of the infrastructure goods that the bonds finance. Revenue bonds are generally project-specific, financing a particular capital asset—such as a bridge, hospital, or utility project—that may generate the revenue to make up the cost of retiring the debt. However, there are many ways to structure bond repayment. Common repayment sources include special assessment taxes and tax increment financing, which allocate a portion of property taxes in an area subject to bond-financed improvements. Alternatively, non-revenue-generating assets such as schools or public buildings may be financed through a leaseback arrangement in which an off-balance-sheet authority issues revenue bonds to pay for a facility, then rents the facility to a municipality, using the rental income to meet incurred debt payments. 

Revenue bonds are often issued by municipal subsidiaries such as public authorities and special districts. Debt issued through these government units is a form of off-balance-sheet finance that doesn’t contribute to the legal debt limits that states and localities may otherwise be subject to. As independent borrowers with less depth of revenue to draw on and less history of borrowing, public authorities and special districts may be deemed riskier investments by bond raters and buyers. In turn, revenue bonds are typically higher yielding than general obligation bonds. Despite these higher interest costs, state and local governments issue a larger dollar amount of revenue bonds, as can be seen in Figure 1 below. 

Figure 1. 

The vast majority of outstanding municipal debt receives a tax exemption. This means that investors are not subject to federal income tax on the interest income they receive from these securities.¹ This in turn produces a financial value measurable in terms of the “tax-equivalent yield.” Assuming the purchaser of a security has sufficient tax liability to benefit from the exemption, the yield on a tax-exempt municipal bond is equivalent to that of a comparable but higher-paying taxable security.² The Public Finances Network estimates that the average spread between taxable and tax-exempt bonds is equal to 210 basis points, or 2.1 percent.³ Thus as a result of the tax exemption, municipalities can borrow at a lower interest rate than they would without the exemption. 

To understand why municipalities issue debt and why their liabilities receive preferential tax treatment, it is necessary to place municipal borrowing within the broader context of US public finances. Historically, municipal debt issuance preceded the introduction of federal income taxes, as well as many of the other fiscal responsibilities now associated with the federal government. In the late 18th and early 19th centuries, states played the predominant role in public finance, chartering corporations and issuing debt to pay for banks, canals, and transportation infrastructure. 

What Are the Uses of Municipal Debt?

The majority of infrastructure spending in the US occurs at the state and local level, even accounting for federal investment in defense-related infrastructure—though nondefense spending provides a more comparable picture. Since the 1970s states and localities have rapidly outpaced the federal government on infrastructure spending.⁶

Figure 2.

While a greater share of federal spending consists of capital investment (i.e., spending on new infrastructure) than operations and maintenance, state and local governments still spend more in both categories. 

Figure 3.

The growth in operations and maintenance (O&M) spending as a share of total public infrastructure spending (depicted in Figure 3) can in part be explained by the growth in size of the overall stock of infrastructure. Understandably, as the stock of infrastructure grows and ages, upkeep costs rise. Furthermore, as many physical structures are long lasting, it is natural that new investment will fall for at least certain categories. For example, the growth of highways likely cannot continue apace indefinitely. However, research suggests that investment lags behind desirable social and economic levels . Underlining this point, while nominal spending has continued to rise, total public spending on infrastructure has stagnated, measured in inflation-adjusted terms⁷ and as a percentage of GDP.

Figure 4.

Figure 5.

Figures 6 and 7 show trends in public infrastructure spending by category of investment. The completion of the federal highway system marks a significant point in total spending, particularly in federal spending.

Figure 6.

Figure 7.

The predominant role of state and local governments in infrastructure finance is further accentuated by the fact that grants to subnational governments comprise a significant portion of the federal investment figured above. The Congressional Budget Office (CBO) reports that in 2023, $93 billion (of the federal government’s total infrastructure spending of $131 billion) went to state and local governments. While these CBO figures only reflect water and transportation infrastructure spending, the Office of Management and Budget (OMB) provides an alternate estimate of federal physical capital investment outlays.⁸ Encompassing a broader range of investment categories, the OMB shows that in 2023, grants made up $111 billion of the total $356 billion in federal investment for 2023, with 72 percent of these grant funds going toward highways and mass transit.⁹

In this context, the municipal bond market provides by far the most significant source of municipal infrastructure finance. The outstanding debt of the municipal bond market is over $4.1 trillion. The vast majority of this debt (approximately 85 percent, or over $3.5 trillion as of Q4 2024) consists of tax-exempt bonds. There are over 36,000 issuers of more than 1 million municipal bonds, consisting of states, cities, counties, tribal governments, school districts, public authorities, and special districts. Figure 8 shows a map of municipal bond issuance in 2024, aggregated by state. California led US states, with aggregated issues totaling $71.8 billion. It was followed by Texas ($68.1 billion), New York ($58.8 billion), Florida ($27.5 billion), and Illinois ($17.4 billion).

Figure 8. 

In using the bond market, municipalities pledge future revenues so as to increase the current availability of liquid assets. By doing so, they are able to make large upfront expenditures on fixed investment and service delivery. This borrowing is largely used to finance infrastructure in water utilities, education, health care, housing, and transportation. Figure 9 presents categories for 2024.¹⁰

Figure 9.

As shown in Figure 9, the two largest categories in 2024 were “education” and “general purpose” expenditures.¹¹ While higher education bonds can be serviced through income sources such as tuition and fees, primary and secondary education do not have recourse to these revenue streams. Instead, education bonds are typically paid for by general taxes (if they are issued as general obligation bonds) or by an allocated revenue stream, such as a percentage of property or sales taxes (if issued as revenue bonds).

3. Private Finance and the Municipal Bond Market

Municipal debt is traded “over the counter” through broker-dealer networks rather than at a centralized location, as stocks are. This makes the market fragmented and costly, decreasing liquidity and limiting information transparency. Given this fragmentation and illiquidity, a few types of actors play key roles in making the market. These actors are critical in shaping the conditions under which states and localities issue the bonds necessary to pay for essential infrastructure and services. 

Municipal debt issuance involves primary and secondary markets. In the primary market, a municipal issuer sells new securities to a broker-dealer known as an underwriter. These dealers operate out of departments within traditional financial institutions such as banks or securities firms, and can act individually or in groups known as underwriter-syndicates. Underwriters then sell the securities to investors in a primary offering.¹² The difference between what the underwriters pay to the issuer and the amount they receive from investors is known as the underwriter spread. 

The secondary market for municipal securities encompasses trades that occur after the primary offering. The secondary market is relatively illiquid, with many purchasers holding bonds until maturity. Public information is relatively limited, which favors institutional investors over individual traders.

Other actors involved in issuing and trading these securities include bond counsel and financial advisors, rulemaking boards such as the Municipal Securities Rulemaking Board (MSRB), and private credit rating agencies. Bond counsel represents bondholders, providing legal opinions on securities and assuring that all procedural steps have been completed and relevant tax determinations considered. Financial advisors help municipalities to coordinate auction bids or select an underwriter, and serve a fiduciary duty to the issuing municipality. The 1975 Securities Acts Amendments gave the Securities and Exchange Commission (SEC) regulatory and enforcement authority over municipal bond broker-dealers and banks, and created the MSRB to create rules for these actors in the municipal bond market.¹³ Significantly, the law prohibited the SEC or MSRB from enacting disclosure requirements on municipalities. 

Lastly, private ratings agencies such as Moody’s, Standard & Poor’s, and Fitch assess municipal credit quality, which in turn informs the prices paid and liquidity on the primary and secondary markets. Given the large number of municipalities that issue debt, and the variety of debt structures on the municipal bond market, credit raters play a significant role in dictating credit conditions. 

The different financial actors that purchase municipal debt participate in this market for various reasons. Costs are higher for individual retail investors, who typically purchase smaller quantities (under $100,000), compared to institutions, which typically purchase in large amounts (over $1 million). While individuals receive a relatively low-risk stream of tax-exempt income, institutions may purchase on behalf of their individual clients or as part of a particular portfolio management strategy. 

Ownership of municipal debt is split nearly evenly between individual and institutional owners. Among institutional investors, the largest holders are mutual funds (26 percent), followed by insurance companies (13 percent), then banks (10 percent), and other holders, as shown in Figure 10. Individuals directly hold 47 percent of the overall municipal debt market. Examining individual ownership by age reveals that 60 percent of holders are over the age of 65, roughly in line with the general demographic distribution of wealth. 

Figure 10.

4. Limitations and Inequities of the Municipal Bond Market

Since the vast majority of municipal bonds offer a tax exemption, they are of the greatest value to those with a higher tax burden. The higher an investor’s marginal income tax rate, the greater the tax-equivalent yield of any particular tax-exempt bond. In turn, this means that municipalities have to offer higher rates to attract investors from lower income tax brackets. This results in lower tax revenue as public investment is made dependent on municipalities’ ability to entice wealth holders through subsidies to capital income. 

By providing interest income and exemption from federal and sometimes state income taxes, municipal debt can compound existing disparities in wealth, whereas an enhanced system of direct taxation could instead more efficiently redistribute it. Eizenga and Hanlon find that 10 to 20 cents of every dollar exempted from federal income taxes is captured by bondholders, rather than municipalities in the form of lower borrowing costs. Furthermore, Bergstresser and Cohen find that the share of households holding municipal debt (both directly and through mutual funds) has shrunk over time and primarily consists of those at the top of the wealth distribution. Concentration of household ownership of municipal debt has grown more pronounced over time, with the wealthiest one-half of 1 percent increasing its share from 24 to 42 percent between 1989 and 2013. Furthermore, the top 10 percent of wealth holders possess almost 90 percent of the total value of household holdings of municipal securities.

One response to this critique is that these rewards can be partially, if not totally, offset through the gains to users of municipal services. Improved water infrastructure can improve employment, health, and quality of life. Renovating hazardous education facilities can improve student educational and health outcomes. However, access to the municipal bond market is unequal, affecting the terms of financing offered and the availability of services it funds. Direct subsidies to borrowers could achieve greater efficiency and equity through a targeted redistributive policy. 

A further defense of the tax exemption might be that the provision of public infrastructure and services through borrowing can serve to avoid confrontations that may arise over efforts to raise taxes. However, issues of taxation cannot be avoided by borrowing, given that debt issuance relies on securing some source of revenue that ultimately falls on the public. In turn, the tax revolts of the 1970s limited the ability and political will to issue general obligation bonds. 

A second criticism of municipal bond finance concerns inequities associated with the distribution of the costs of debt payment and the benefits of the services financed. The taxes and fees that secure debt repayment can be regressive when they are structured as flat taxes or user fees. Some groups (such as Black people, other minority groups, and people experiencing poverty) are consistently barred from debt issuances to their benefit while paying for improvements they do not receive. In his study of postwar San Francisco, Destin Jenkins summarily describes this dynamic when he writes that “Black neighborhoods were continuously deemed unworthy of debt.”¹⁴ In this context, underwriter syndicates functioned as elite, racially exclusive social clubs, and credit agencies specifically included categories such as the percentage of Black residents when assessing cities’ creditworthiness. The compounding effect of this dynamic was to entrench racial, economic, and geographic inequalities. While such explicitly racist criteria are no longer included in credit determinations, inequitable access and borrowing terms persist. Multiple studies have found statistically significant positive and economically meaningful correlations between an issuer’s percentage of Black residents and its cost of borrowing, controlling for other variables affecting bond yields. Loftus, McCoy, and Zhang identify a similar dynamic for tribal governments compared to other borrowers. Lastly, Backer, Schirmer, and Anti find that up to a certain threshold, an increase in the number of white students in a school district is correlated with a statistically significant decrease in school district borrowing costs, controlling for a range of credit-determining factors. 

These findings highlight an additional consideration with regard to municipal debt finance: As structured, it subjects the provision of public services and public governance writ large to the particular interests of private financial market actors. In turn, these actors may use subjective determinations (such as the explicitly racist ones cited above) in their decision to provide or withhold credit, reinforcing existing disparities. Historical precedent reveals the ways in which the bond market’s financial claims can override the claims of public service beneficiaries and employees. Notoriously, in the case of New York City’s fiscal crisis, the city’s inability to negotiate sales of new debt led to the oversight of the Emergency Financial Control Board (in which private economic interests were given a high degree of representation) and the drastic rollback of city services and employment.

This underscores a further point of contention: The issuance of municipal bonds is highly opaque and technocratic. There is a structural lack of democratic accountability in the decision-making process over which projects are selected for approval, how this selection occurs, and whose voices are heard. While general obligation bonds typically require a referendum, their uses may be selected prior to public appeal. Revenue bonds issued by public authorities require no public referendum, making the provision of services subject to the discretion of government officials with limited public feedback. The dangers of this sort of top-down, circumscribed decision-making in urban governance have been particularly well noted in the context of 20th-century urban renewal, though they by all means persist to this day. On the other hand, municipal debt issuance provides one of the faster-acting methods for municipalities to select and pay for projects, which is of value given the time-limited window to mitigate and adapt to global temperature rise. 

Additionally, climate change poses an immense risk to the architecture of municipal finance. There is a growing body of research showing an increase in bond yields in localities afflicted by higher risk of climate-related events. However, pricing of climate risk remains inconsistent and inadequate, with limited incorporation into disclosure practices or credit rating decisions. This suggests a general underpricing and lack of acknowledgment of the risks in question. Without ex ante measures to address the sources of and exposure to climate risk, there is an increased danger that the political response will be piecemeal and disorderly at best, punitive and regressive at worst. 

Lastly, a final consequence of financial dependence on the municipal debt market is the issue of macroeconomic procyclicality¹⁵ and fragility. During periods of economic downturn or macroeconomic shock, municipal borrowing may appear riskier to investors and credit raters, due to declining revenues and rising unemployment or due to diminishing liquidity in financial markets. This was exemplified recently when “municipal bond yields in the states and cities hit hardest by the pandemic witnessed the largest spike in yields, despite having underlying healthy credit fundamentals.”¹⁶ During the financial tumult precipitated by the COVID-19 pandemic, the Federal Reserve announced the creation of the Municipal Liquidity Facility to provide emergency liquidity relief. Despite limited engagement with the facility, its announcement reassured the municipal bond market. However, as an emergency facility created by the Federal Reserve, this measure remained discretionary. Feygin and Reddy argue that without a guaranteed backstop of some form, municipal investment in infrastructure and services remains exposed to macroeconomic fragility. This fragility limits municipalities’ capacity to make necessary investments in public goods—such as climate mitigation and adaptation—and continues to grow as climate change increasingly leads to macroeconomic and financial risk.

5. Responses to Challenges in Municipal Finance

The previous section outlined issues of equity, efficiency, transparency, liquidity, and fragility in the municipal bond market. Several policies have either been proposed or implemented in limited form to address one or more of these concerns. They vary in the level of public oversight they aim to effect, as well as in the area of market governance in which they intervene. While no one policy addresses every issue raised, these provide a baseline suite of options that can be amended or combined. 

1. Unions can allocate pension assets to local bond-financed infrastructure projects, aka “fiscal mutualism.”
2. The Federal Reserve can expand the Municipal Liquidity Facility.
3. National policymakers can renew a federal subsidy to municipal borrowing in lieu of the federal tax exemption.
4. National policymakers can create a new municipal government–sponsored enterprise or national infrastructure bank that can pool municipal securities and issue high-quality liquid debt.
5. State policymakers can develop and expand state bond banks.
6. Financial regulators and credit rating agencies can implement enhanced disclosure requirements, including for climate risk and the use of proceeds from general obligation bonds. 
7. Financial regulators and credit rating agencies can implement performance-based credit ratings for municipal bonds. 

The municipal bond market is a crucial channel for financing public investment. This brief has outlined the key features of this market and suggested areas where policymakers and the engaged public can direct their efforts to strengthen public capacity to deliver material needs. The policies listed above can serve as the basis for further research, experimentation, and reform towards ensuring that municipal finance supports a democratic economy for all.