Alan D. Viard of American Enterprise Institute has said that the federal government of america should prohibit state governments from exempting income from in state munincipal bonds unless out of state munincipal bonds are also exempted. These exemptions discourage local governments from selling bonds to out of state investors and discourage in state investors from buy out of state bonds. This increases inefficiencies and expenses while reducing liquidity and diversification. For more, see here.
But if the costs were as high as Viard says, then local governments and local investors would try to reduce their costs by lobbying their state government to end the exemption for local bonds. Local governments and local investors are not objecting to the exemption for local bonds; therefore the cost is not as high as Viard says.
A national market in munincipal bonds would have greater liquidity and diversification than a local market. However, a local market will have almost as much diversification and liquidity as a national market if the bonds are insured in a national bond insurance market. Many munincipal bonds are already insured in a national bond insurance market. Probably the exemption for local bonds has contributed to the development of the national bond insurance market.
A national munincipal bond market would have more competition, which would be good for investors and for local governments. There would be more competition between local governments to sell bonds, and there would be more competition between investors to buy bonds. But a national munincipal bond market would be regulated by the central government, so there would be less local control.
The most important part of competitive federalism is competition between regulators. If there is a national munincipal bond market, then the market is regulated by the central government, there is one monopoly regulator, there is no competition betweeen regulators. But if each state regulates its own munincipal bonds, then each state is an regulator, and these state regulators compete with each other.
It is not neccessary for each state to have a totally seperate munincipal bond market. Groups of states could form multistate markets, which would provide the advantages (and disadvantages) of larger markets, which still providing for competition between multistate markets.
To maximise competition between states, the state governments should have as much freedom as possible to make laws which are different than other states. Therefore the central government should avoid telling state governments what laws the states must or must not have. There should be as much local control as possible. The central government should not interfere in state affairs unless a state is violating human rights or harming another state.