Working Paper: NBER ID: w3017
Authors: Gilbert E. Metcalf
Abstract: The federal tax code creates strong incentives for tax arbitrage activity on the part of state governments. This arbitrage activity is illegal and previous research has typically assumed that the constraint against arbitrage activity is binding. This paper explicitly tests this proposition by considering whether financial asset holdings increase as the yield spread between taxable and tax exempt securities rises. Using a data set on 40 state governments over a 7 year period, I find that there is a significant response to changes in the yield spread. One implication of these results is that the Tax Reform Act of 1986 which made even greater efforts to curb arbitrage activity is likely to be ineffective.
Keywords: arbitrage; state governments; financial assets; tax-exempt securities
JEL Codes: H72; H74
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| yield spread (E43) | financial asset holdings (G19) |