State and local government bonds pay interest that are generally exempt from Federal income tax, but the state income tax treatment can vary. The New York state income tax, for example, exempts only New York bonds, and the state income tax is imposed on bonds issued by other states.
The major exception is Puerto Rico bonds, the interest income from which is exempt from income tax by all US state and local governments. Puerto Rico bonds accordingly have become very attractive to people who live in states and cities with high state and local taxes, such as New York City (8.82% state income tax + 3.876% local income tax) or California (13.3% state income tax). The result is that the vast majority of state-specific municipal bond funds, ostensibly designed to own only bonds issued by New York or another single state, also own substantial amounts of Puerto Rico bonds.
The state/local tax exemption for Puerto Rico government bonds has been around since 1917, as provided by the Jones-Shafroth Act that also granted US citizenship to Puerto Ricans and established a bill of rights. The exemption is one of the most stable features of the US income tax rules and is a requirement imposed by federal statute, so states cannot choose to tax Puerto Rico bonds even if they want to.
Unfortunately, the generous tax break for Puerto Rico government debt has caused the Puerto Rico government to go overboard in borrowing money, to the tune of $58 billion. That equates to $15,700 of debt per Puerto Rican, where the per capita income is around $16,300. The value of Puerto Rico debt has declined by around 20% in value in the past year, which has more than wiped out the benefit of any tax break for Puerto Rico debt.
Some of Puerto Rico's economic troubles can be attributed to the expiration in 2006 of certain tax credits for businesses that operate in Puerto Rico, under Internal Revenue Code sections 30A and 936.