The tax exemption is more than a subsidy—it represents good governance.
Nothing shakes the municipal bond market like a threat to the tax exemption. Every three or four years, it hits the radar again for one reason or another. The industry response is predictable: throw a static, yet staggering, number at Congress to illustrate the cost of borrowing if the exemption were removed. The argument always ties back to the essential services provided by state and local governments—public schools, roads, water infrastructure, emergency services.
But let’s be honest. Municipal bonds have also funded Yankee Stadium. And Citi Field. And the private American Dream Mall. And a NASCAR speedway. And a trash incinerator that bankrupted a state capital. Maybe the original intent of the exemption has drifted a bit.
“Eliminating the tax exemption would raise borrowing costs by $823.92 billion over the next decade, resulting in a $6,554.67 tax and rate increase for each American household,” the Government Finance Officers Association (GFOA) recently warned Congress.
That focus on Main Street—on cost savings and essential infrastructure—has been the industry’s go-to defense, and it has worked in the past. But in today’s climate, numbers alone won’t cut it. The conversation needs a real narrative—one that resonates beyond policy circles.
The Tax Exemption is a Shield—Not Just a Subsidy
The exemption does more than reduce borrowing costs—it protects the municipal market from the volatility, speculation, and activist pressures that can characterize the taxable bond market.
Municipal bonds, because of their tax-exempt status, operate in a largely distinct and insulated marketplace. They cannot be shorted in the same way corporate bonds can. They are not easily leveraged, making them unattractive to hedge funds and activist investors who thrive on financial engineering. The exemption ensures that municipal bonds remain primarily a buy-and-hold asset and appealing to long-term investors like banks and insurance companies rather than speculative traders.
This structural separation has a profound governance benefit: it creates a barrier between issuers and investors. Unlike corporate bonds—where investors often push for governance changes or financial restructuring—municipal bonds exist in a space where the relationship between state and local governments and their creditors remains largely transactional. This reduces political and financial interference.
Making the muni market taxable would dismantle this protective barrier, pulling cities and states into the world of activist investors, hedge funds, and aggressive market behavior. The muni market would begin to function more like the corporate bond market, where investors see their holdings not just as passive financial instruments, but as levers of control.
What’s the Alternative?
The real issue isn’t just that Congress is considering removing the exemption. It’s that there is no alternative. If the exemption is eliminated, what replaces it?
Maybe it’s 50 state bond banks. Maybe it’s a national infrastructure bank. Maybe it’s a sector-by-sector set of financing authorities that blur the line between public and private debt—funding monopolized sectors like healthcare and transportation while states cede financial control under the guise of cost constraints. Some of these alternatives could actually be more efficient and accretive to public interest than the current system but that would need to be curated, created and promoted- something that is unlikely to happen right now. In practice at this moment in history, removing the exemption would change the muni market into something much more volatile—and far more vulnerable to a new class of investors.
The Rise of Activist Investors in the Muni Market
CSG’s greatest concern isn’t higher borrowing costs—it’s the unintended consequence of inviting activist investors into the municipal bond market. In corporate and sovereign debt markets, creditors don’t just passively collect interest. They leverage their holdings for power—pushing financial, operational, and even political changes to maximize returns.
If municipal bonds lose their tax exemption and become just another taxable asset class, the same activist tactics used in corporate and sovereign finance could infiltrate state and local government debt markets.
Skeptical? Let’s Talk Precedent.
A critic might argue: State and local governments don’t have corporate charters, shareholders, or boards of directors. They have protected constitutions, laws against pay-to-play, and elected officials who answer to the people, not to Wall Street.
Sure. But the past two decades have shown that financial markets can and do override political norms. Citizens United blurred the line between corporate influence and democracy. Crypto has tested the boundaries of financial regulation. And corporate activist investors have already weaponized bond ownership.
How Bond Investors Influence Corporate & Sovereign Behavior
Corporate Debt: Bondholders as De Facto CEOs
Elliott Management & Telecom Italia (2018-2020) – Elliott, a hedge fund, used its bondholder status to pressure the company’s board, successfully reshaping executive leadership and strategy.
Carl Icahn & Caesars Entertainment (2019) – Icahn acquired a stake in Caesars’ debt and used it to push for a merger, demonstrating how bondholders can force major corporate decisions.
Sovereign Debt: Political Leverage Through Credit Ownership
Argentina & Vulture Funds (2001-2016) – Hedge funds like Elliott Management refused to restructure Argentina’s defaulted bonds, leading to a 15-year legal battle that forced major policy concessions.
Greece & the Troika (2010s) – The European Central Bank (ECB) and the International Monetary Fund (IMF) used debt restructuring talks to impose austerity measures, effectively overriding Greece’s democratic policy decisions.
What Happens When This Comes to Municipal Bonds?
If the muni market shifts toward a corporate-style taxable model, a different class of investors will emerge—ones seeking not just returns, but control. The implications for state and local governments could be profound:
1. Increased Political Leverage by Bondholders
Activist investors could pressure governors, mayors, and state legislatures by forcing bond downgrades, demanding policy changes, or influencing fiscal decisions.
Municipal bond ownership could become a tool for private-sector lobbying, where debt is wielded as a political bargaining chip.
2. Forced Privatization of Public Assets
Bondholder-driven governance could push municipalities toward asset sales to meet debt obligations. Think roads, water utilities, transit systems—auctioned off to private equity in debt restructuring deals.
Just as corporate creditors demand equity stakes in distressed companies, municipal bondholders could demand control over revenue-generating assets, such as airports, toll roads, and public hospitals.
3. Market Concentration & Predatory Behavior
Large institutional investors could consolidate muni debt ownership, making it harder for small localities to access capital.
Hedge funds, notorious for specializing in distressed debt, could exploit local fiscal crises for profit—extracting high returns at the expense of long-term municipal stability.
4. Volatility & Market-Driven Governance
A taxable muni market would introduce Wall Street-style volatility, where state and local governance becomes dictated by financial markets rather than by public needs.
Imagine a scenario where a small group of asset managers holds a majority of a city’s debt. In a low-liquidity market, even the threat of a sell-off could send valuations plummeting, impacting credit ratings, public trust, and governance decisions.
The Bottom Line: Governance at Risk
Eliminating the tax exemption from municipal bonds wouldn’t stop states and local governments from issuing debt—but it would change the nature of that debt. It would introduce the same activist investor playbook that has shaped corporate and sovereign finance, turning municipal bonds into a battleground for political influence.
This shift wouldn’t just increase borrowing costs. It could fundamentally alter the balance of power between public officials and private capital, creating a chaotic financial environment where governance is dictated not by voters, but by bondholders.
The exemption is more than a subsidy. It is a safeguard—one that ensures municipal finance remains a tool for public investment, not private control.