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.
*Published:
The Review of Economics and Statistics, Vol. LXXII, No. 3, pp. 390-396, (August 1990).
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