Who receives most of the benefit from the federal tax exemption on state and local government bond interest?
The federal tax exemption for interest earned on state and local government bonds mainly benefits the governments that issue the bonds. This is because it allows them to sell tax-exempt bonds with lower interest rates than comparable taxable bonds, and investors will still buy these bonds as long as their after-tax profits are equivalent or greater. Hence, the tax exemption allows governments to issue bonds at lower interest rates, which lowers their costs of financing. Per the IRS, "The interest rate on tax-exempt bonds is generally lower than the interest rate on taxable bonds of the same maturity and risk, with the difference approximately equal to the tax rate of the typical investor in tax-exempt bonds."