STATE AND LOCAL governments, with a strong assist from the bond industry, are trying to overturn a fair and sensible provision of the Social Security reform measure passed last March. The provision in question requires that, in determining whether elderly persons have sufficient income to be subject to income tax on Social Security benefits, all income-- including tax-exempt income--be counted.

The justification for the provision is obvious. Congress decided that, with the Social Security system in severe financial trouble, it no longer made sense to allow well-off recipients to escape income taxation on all of their benefits. But Congress wanted to be sure that the new tax would not cause economic hardship to elderly or disabled people. So it decided to exempt at least half of benefits from any taxation and to tax the remainder only when an individual had more than $25,000 in total income or when a couple had more than $32,000.

In measuring economic hardship, it obviously makes no sense at all to exclude from the count certain kinds of income that can make some people very well-off indeed. Interest received from municipal bonds is an example. What possible fairness could there be in allowing a person with $100,000 in such receipts to escape taxation on Social Security benefits when another person with only $25,000 in income from a private pension has to pay?

Fairness to individuals, however, is apparently not at the top of state and local governments' lists of concerns. They are more worried about any change in federal law that might make their tax-exempt bond issuances less attractive to investors. As for the bond salesmen--who have been mounting expensive publicity campaigns for repeal of the provision--they are licking their chops at the opportunity to market special tax-exempt packages to the retired if such income isn't counted in determining taxation of Social Security benefits.

In fact, the new law would have only a marginal effect on a person's decision to invest in tax-exempts rather than higher-paying taxable investments. For people who want to avoid being pushed into the bracket where Social Security taxation would apply, tax-exempts will actually become a more, rather than less, attractive investment. But the states are worried that the new law might be a step toward eliminating tax-exempt bonds altogether--a move that would certainly improve the fairness of the federal tax code.

An 1895 Supreme Court decision held that the federal government is barred from taxing municipal bond interest, but many tax authorities doubt that the court would uphold that earlier finding if the issue arose again. In any case, the current law does not tax the interest. It simply counts it--as do numerous welfare laws--in determining whether the taxpayer is needy enough to be eligible for a special benefit, exemption from taxation on Social Security. There are, no doubt, far more egregious inequities in the tax code than would be produced by exempting municipal bond interest from the Social Security calculation. But that is no excuse for putting another bad law on the books.