Expected Future Tax Policy and Tax-Exempt Bond Yields

James M. Poterba

NBER Working Paper No. 1469 (Also Reprint No. r0746)
Issued in August 1986
NBER Program(s):   ME   PE

This paper tests several competing models of municipal bond market equilibrium. It analyzes the influence of changes in both personal and corporate tax reforms on the yield spread between taxable and tax-exempt interest rates. The findings suggest that changes in personal income tax rates have pronounced effects on long-term municipal interest rates, but small effects on short-maturity yields. Corporate tax reforms, however, affect both long- and short-term yields. These results are inconsistent with the view that the relative yields on taxable and tax-exempt bonds are set by banks and insurance companies which are taxed at the corporate rate. They support the more traditional view that banks are the primary holders of short-term muncipal securities, while households are the principal investors in the long-term municipal market. This view suggests that proposals to reform municipal financing policies by increasing the use of short-term borrowing, or issuing long-term floating-rate debt, could reduce the real cost of municipal borrowing.

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Published:

• Poterba, James M. "Explaining the Yield Spread between Taxable and Tax-exempt Bonds: The Role of Expected Tax Policy," Studies in State and Local Public Finance, ed. Harvey S. Rosen, pp. 5-49, Chicago: UCP, 1986. ,
• Poterba, James M. and Kim S. Rueben. "Fiscal News, State Budget Rules, And Tax-Exempt Bond Yields," Journal of Urban Economics, 2001, v50(3,Nov), 537-562.

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