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Arbitrage and the Savings Behavior of State Governments

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3017.

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Date of creation: Jun 1989
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Publication status: published as The Review of Economics and Statistics, Vol. LXXII, No. 3, pp. 390-396, (August 1990).
Handle: RePEc:nbr:nberwo:3017

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  1. Edward M. Gramlich, 1978. "State and Local Budgets the Day after It Rained: Why Is the Surplus So High?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 9(1), pages 191-216.
  2. J. Richard Aronson & James R. Marsden, 1980. "Duplicating Moody's Municipal Credit Ratings," Public Finance Review, , vol. 8(1), pages 97-106, January.
  3. Roger H. Gordon & Joel Slemrod, 1985. "An Empirical Examination of Municipal Financial Policy," NBER Working Papers 1599, National Bureau of Economic Research, Inc.
  4. Engle, Robert F., 1984. "Wald, likelihood ratio, and Lagrange multiplier tests in econometrics," Handbook of Econometrics, in: Z. Griliches† & M. D. Intriligator (ed.), Handbook of Econometrics, edition 1, volume 2, chapter 13, pages 775-826 Elsevier.
  5. Hausman, Jerry A. & Taylor, William E., 1981. "A generalized specification test," Economics Letters, Elsevier, vol. 8(3), pages 239-245.
  6. Metcalfe, G.E., 1988. "Federal Tax Policy And Municipal Financial Behavior," Papers 29, Princeton, Woodrow Wilson School - Discussion Paper.
  7. 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.
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Cited by:
  1. Metcalf, G.E., 1989. "Federal Taxation And The Supply Of State Debt," Papers 40, Princeton, Woodrow Wilson School - Discussion Paper.
  2. Maria Cornachione Kula, 2004. "U.S. States, the Medicaid Program, and Tax Smoothing," Southern Economic Journal, Southern Economic Association, vol. 70(3), pages 490-511, January.
  3. Rodolfo Apreda, 2003. "On the Extent of Arbitrage Constraints within Transaction Algebras (A non-standard approach)," CEMA Working Papers: Serie Documentos de Trabajo. 239, Universidad del CEMA.

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