Working Paper: NBER ID: w2900
Authors: James M. Poterba
Abstract: This paper provides clear evidence that the yield spread between long-term taxable and tax-exempt bonds responds to changes in expected individual tax rates, a finding that refutes theories of municipal bond pricing that focus exclusively on commercial banks or other financial intermediaries. The results support the conclusion that in the two decades prior to 1986, the municipal bond market was segmented, with different investor clienteles at short and long maturities. The Tax Reform Act of 1986 is likely to affect this market, however, since it has restricted tax benefits from tax-exempt bond investment by commercial banks. Individual investors are increasingly important suppliers of capital to states and localities, and their tax rates are likely to be the primary determinant of the yield spread between taxable and tax-exempt interest rates in the future.
Keywords: Tax Reform; Tax-Exempt Bonds; Municipal Finance; Yield Spread
JEL Codes: H25; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| individual tax rates (H26) | yield spread (E43) |
| tax policy (H20) | investor behavior (G41) |
| tax policy (H20) | market outcomes (P42) |
| 1986 Tax Reform Act (H20) | yield spread (E43) |
| 1986 Tax Reform Act (H20) | market structure changes (D49) |
| tax changes (H26) | narrowing yield spread (E43) |