The Tax Treatment of Government Bonds

Governments in some developed and in many developing countries have introduced favorable tax treatment for interest on government bonds, in some cases by fully exempting this source of income from taxation. Presumably these special rules reflect the perception that favorable tax provisions will facilitate the placement of government bonds; in other cases, the objective has been to subsidize specific public or quasi-public activities. Similar to most other tax provisions, tax relief pertaining to interest on government bonds has potentially important implications for economic efficiency and distributional fairness. The increasing globalization of economies and financial markets has added important complexities to the impact of taxation on financial flows, including on government debt instruments. This paper surveys present provisions for taxation of interest on government bonds in OECD countries and then proceeds to identify the main economic implications--on efficiency and equity grounds--of exempting interest on government bonds. It demonstrates that the consequences of taxation may differ significantly in closed and open economies, and that in the latter situation the impact of taxation depends, among other things, on whether residence- or source-based taxation is the international norm. The paper concludes that, on economic grounds, there are no reasons for exempting interest from government bonds, and that only administrative difficulties in capturing other forms of interest in the tax net may provide a rationale for doing so.