This paper considers ways in which federal tax policy affects municipal asset and debt holdings. The tax treatment of municipal bonds and income creates an arbitrage opportunity for communities to issue tax-exempt debt and invest in financial assets. The author presents evidence that suggests the rules in effect prior to 1986 to prevent this activity were not effective. He then develops and estimates a model of municipal bond supply. The author finds a semielasticity of 1.23 of long-term debt with respect to the spread between the after-tax rate of return and the municipal borrowing rate.