Working Paper: NBER ID: w5607
Authors: N. Gregory Mankiw; James M. Poterba
Abstract: This paper proposes an alternative to the traditional model for explaining the spread between taxable and tax-exempt bond yields. This alternative model is a special case of a general class of clientele models of portfolio choice and asset market equilibrium. In particular, we consider a setting with two types of investors, a taxable investor and a tax-exempt investor, who hold specialized bond portfolios. The tax-exempt investor holds only taxable bonds, and the taxable investor holds only tax-exempt bonds. Both investors hold equity, and the taxable and tax-exempt bond markets are linked through the equilibrium conditions governing equity holding and bond holding for each type of investor. In contrast to the traditional model, this alternative model has the potential to explain the small observed spread between taxable and tax-exempt yields. In addition, this model predicts that the yield spread between taxable and tax-exempt bonds should be an increasing function of the dividend yield on corporate stocks. Although the substantial changes in the tax code during the last four decades complicate the testing of this model, we find some support for the predicted relationship between the equity dividend yield and the yield spread between taxable and tax-exempt bonds.
Keywords: municipal bonds; tax-exempt bonds; taxable bonds; yield spread; equity dividend yield
JEL Codes: G12; H24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| yield spread between taxable and tax-exempt bonds (H73) | dividend yield on corporate stocks (G35) |
| dividend yield on corporate stocks (G35) | yield spread between taxable and tax-exempt bonds (H73) |
| tax rates on interest income (E43) | yield spread between taxable and tax-exempt bonds (H73) |