From coast to coast, the wealthy are finding themselves in the crosshairs of new higher tax proposals, which could potentially increase demand for municipal bonds from high-net-worth individuals. Sean McCarthy, Head of Municipal Research, explains.
Preparing for rainy days. State financial reserves are often seen as shorthand for state fiscal health. Based on this convention, we conclude that state fiscal health remains strong, as reserves remain near all-time highs, although we observe a modest drawdown of reserves following the depletion of pandemic-related federal funding (See Exhibit 1).
Exhibit 1 – State Reserves (Rainy Day Funds)
U.S. states often cut taxes when reserves are full; between 2021 and 2025, some 27 states cut taxes in one form or another, according to the Center on Budget Policies and Priorities.
At the same time, however, a handful of states have either explored or implemented income tax increases affecting high-earning taxpayers. Several proposals plan to levy state taxes on the wealthy’s net assets, including unrealized gains.
Why are some states shifting to tax hikes on the wealthy? The U.S. has faced an affordability crisis since the high-inflation, post-pandemic period. Americans have endured a surge in the costs of products and everyday services, including for housing, childcare, utilities, and healthcare (See Exhibit 2).
Exhibit 2 – Cumulative Change of Inflation and Average Hourly Earnings Since COVID Lockdowns
Additionally, rising income and wealth inequality continues in the United States; according to data from the Federal Reserve, the top 1% of U.S. households own approximately 30% of all domestic wealth, or equivalent to all the wealth held by the bottom 90% of U.S. households (see Exhibit 3).
Exhibit 3 – Wealth-by-Wealth Percentile Group
The affordability concerns have captured the attention of both parties; for example, the No Tax on Tips Act passed the Senate unanimously in 2025 in a rare instance of bipartisanship. President Trump then incorporated the deduction for tips from federal income taxation in the One Big Beautiful Bill Act (OBBBA). As a further example, Zohran Mamdani’s focus on affordability in New York City helped him get elected mayor of the largest city in the U.S.
States are also contending with an evolving fiscal relationship with the federal government. The federal government has been aiming to reduce support for various social programs and disaster aid under the Federal Emergency Management Agency (FEMA). The OBBBA mandates approximately $1 trillion in Medicaid funding cuts for the states over the next decade. To ease the burden of higher gas prices since the conflict in the Middle East, the federal government is also considering a federal gas tax holiday which may deprive states of federal funding for transportation. States will need to determine whether to backfill cuts to federal aid from their own sources (e.g., reserves or taxes) or curtail benefits.
New proposals are emerging in response to these trends. States contending with federal cuts while looking to ease affordability concerns and maintain or expand services may require additional revenues that could influence decisions to raise tax rates. Given the increased focus on affordability and income inequality, the wealthy may be taxed more than they have in the recent past.
In 2021, New York State increased the top marginal tax rate on income over $1 million to 9.65% and introduced two new brackets for filers earning more than $5 million. In 2022, Massachusetts passed the “Fair Share Amendment” which added a 4% surtax on income above $1 million beginning in 2023.
More recently, Maryland in 2025 introduced two new tax brackets, including a 6.25% tax rate applicable to tax filers with income over $1 million, and added a 2% capital gains surcharge for individuals with income over $350,000. Maine also passed a 2% surcharge on individuals with income over $1 million to support public services and offset cuts to federal funding.
In March, Washington State passed the first income tax in nearly a century in the Evergreen State, instituting a 9.9% rate on households with income over $1 million. Assuming this tax survives legal challenges, revenue raised will allow the state to, among other things, eliminate state sales taxes on diapers and over-the-counter drugs, and fund school meals.
Additionally, Minnesota and California are contemplating imposing wealth taxes on their richest residents. These wealth taxes apply surcharges on the net assets, including unrealized gains, of the wealthy and will face serious implementation and constitutional challenges that may make their adoption unlikely, although these challenges have not deterred advocates of these proposals.
Efforts to raise taxes on the wealthy may eventually extend beyond states. Recently, two congressional Democrats with possible 2028 presidential aspirations, Senator Cory Booker and Senator Chris Van Hollen, have proposed eliminating federal income taxes for lower tax brackets while funding the cuts through various tax increases on the wealthy. Historically, there appears some room between the top federal marginal income tax rate of 37% and historical average of 57%.
Exhibit 4 – Highest Federal Income Tax Bracket (Married-Joint)
There are two key implications for municipal bonds. First, higher taxes on the wealthy may accelerate wealth leaving high-tax states. This is a debated topic among academics and policy experts; studies often conclude that tax incentives only marginally influence migration among the wealthy. Other variables, including personal and professional affiliations, discourage high earners from moving out of high-tax jurisdictions.
Nevertheless, states with high marginal income tax rates demonstrate greater population loss, with low-tax states demonstrating population increases (See Exhibit 4). Income tax rates on top earners in high tax states exceed 50% when including federal income taxes and the net investment income tax of 3.8% from the Affordable Care Act. California high earners are subject to a tax rate that is over 14 percentage points higher than Texas or Florida where no personal income tax is collected.
Exhibit 5 - State Personal Income Tax Rate and Net Migration as % of 2022 Population
Source: Mandal, Abir. “Americans are Moving to States with Lower Taxes and Sound Tax Structures.” (Tax Foundation, April 2026).
Demographics, including population shifts, can have a material impact on municipal credit. Declining in-state wealth from population loss may result in less business formation and lower tax collections. Declining tax collections could also incentivize states to: raise taxes in the future to maintain spending; or cut spending to adhere to balanced budget requirements. States and local governments may also curtail bond issuance for critical infrastructure as the population and tax base decline.
Second, higher taxes should contribute to higher demand for municipal bonds. Federal tax filers with adjusted gross income of $1 million and higher claim approximately one-third of all tax-exempt interest on federal tax returns. All things being equal, higher federal tax rates will increase the size of the tax shield available from municipal bonds and lead to greater demand by high-net-worth individuals.
Many states also exempt from state taxation the interest earned on municipal bonds issued by municipal issuers domiciled inside the state. Accordingly, when state tax rates increase, there may be an economic incentive for in-state residents to own more municipal bonds from issuers domiciled inside the state.
Municipal issuers may respond to the loss of population and wealth by reducing the future supply of municipal bonds, increasing the scarcity value of the existing stock of municipal debt by issuers domiciled in that state while in-state demand increases.
Conclusion. States are contending with less federal support given a desire by the federal government to cut expenses and shift costs down to the states. Additionally, rising income and wealth inequality are triggering calls for the wealthy in certain states to shoulder a greater burden of funding for social programs. Municipal bonds will play a critical role in shielding the income of high-net-worth individuals from higher state and federal taxes.
Additionally, declines in populations and wealth may also have negative implications for state budgets and could result in less future municipal bond issuance by negatively affected municipal borrowers.
In the aggregate, these conditions are supportive of increased demand for municipal bonds as a tax shield among high-net-worth individuals.
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