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Tax Reform and the Market For Tax-Exempt Debt

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2900.

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Date of creation: Mar 1989
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Publication status: published as Regional Science and Urban Economics, Vol. 19, No. 3, pp. 537-562, (August 1989).
Handle: RePEc:nbr:nberwo:2900

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  1. Cutler, David M, 1988. "Tax Reform and the Stock Market: An Asset Price Approach," American Economic Review, American Economic Association, American Economic Association, vol. 78(5), pages 1107-17, December.
  2. Buser, Stephen A. & Hess, Patrick J., 1986. "Empirical determinants of the relative yields on taxable and tax-exempt securities," Journal of Financial Economics, Elsevier, Elsevier, vol. 17(2), pages 335-355, December.
  3. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, American Finance Association, vol. 32(2), pages 261-75, May.
  4. Metcalf, G.E., 1988. "Arbitrage And The Savings Behavior Of The State And Local Governments," Papers, Princeton, Woodrow Wilson School - Discussion Paper 30, Princeton, Woodrow Wilson School - Discussion Paper.
  5. Miller, Merton H. & Scholes, Myron S., 1978. "Dividends and taxes," Journal of Financial Economics, Elsevier, Elsevier, vol. 6(4), pages 333-364, December.
  6. Roger H. Gordon & Joel B. Slemrod, 1986. "An Empirical Examination of Municipal Financial Policy," NBER Chapters, in: Studies in State and Local Public Finance, pages 53-82 National Bureau of Economic Research, Inc.
  7. Trzcinka, Charles A, 1982. " The Pricing of Tax-Exempt Bonds and the Miller Hypothesis," Journal of Finance, American Finance Association, American Finance Association, vol. 37(4), pages 907-23, September.
  8. Kidwell, David S & Trzcinka, Charles A, 1982. " Municipal Bond Pricing and the New York City Fiscal Crisis," Journal of Finance, American Finance Association, American Finance Association, vol. 37(5), pages 1239-46, December.
  9. James M. Poterba, 1986. "Explaining the Yield Spread between Taxable and Tax-exempt Bonds : The Role of Expected Tax Policy," NBER Chapters, in: Studies in State and Local Public Finance, pages 5-52 National Bureau of Economic Research, Inc.
  10. Kochin, Levis A & Parks, Richard W, 1988. " Was the Tax-Exempt Bond Market Inefficient or Were Future Expected Tax Rates Negative?," Journal of Finance, American Finance Association, American Finance Association, vol. 43(4), pages 913-31, September.
  11. Daniel R. Feenberg, 1980. "Does the Investment Interest Limitation Explain the Existence of Dividends?," NBER Working Papers 0530, National Bureau of Economic Research, Inc.
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