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Do municipal bond yields forecast tax policy?

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  • Peter Fortune

Abstract

During the recent flat tax debate, interest rates on long-term municipal bonds rose relative to the rate on U.S. Treasury bonds. This was widely attributed to expectations of a reduction in future tax rates. While an axiom of finance states that current asset prices reflect expectations about future events, there is no consensus on how sensitive municipal bond yields are to expectations about future tax rates. This study assesses that question by examining the relationship between the implicit tax rate and actual future tax rates.> Efficient markets theory predicts that the implicit tax rate--the tax rate that equates the after-tax yield on a Treasury bond to the yield on a tax-exempt bond--will be an excellent predictor of future tax rates. The author finds that although the Efficient Markets prediction is not supported, implicit tax rates do contain some information about future tax rates. The information content in implicit tax rates is particularly high around the time of major tax debates that have resulted in significant changes in tax rates. At other times, including the flat tax debate of 1996-96, implicit tax rates carry little information about future tax rates.

Suggested Citation

  • Peter Fortune, 1996. "Do municipal bond yields forecast tax policy?," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 29-48.
  • Handle: RePEc:fip:fedbne:y:1996:i:sep:p:29-48
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    Citations

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    Cited by:

    1. Crowder, William J. & Wohar, Mark E., 1999. "The changing long-run linkage between yields on Treasury and municipal bonds and the 1986 Tax Act," Review of Financial Economics, Elsevier, vol. 8(2), pages 101-119.
    2. Slemrod, Joel & Greimel, Timothy, 1999. "Did Steve Forbes scare the US municipal bond market?," Journal of Public Economics, Elsevier, vol. 74(1), pages 81-96, October.
    3. Ayers, Benjamin C & Cloyd, C Bryan & Robinson, John R, 2005. ""Read My Lips . . .": Does the Tax Rhetoric of Presidential Candidates Affect Security Prices?," Journal of Law and Economics, University of Chicago Press, vol. 48(1), pages 125-148, April.
    4. Poterba, James M. & Rueben, Kim S., 2001. "Fiscal News, State Budget Rules, and Tax-Exempt Bond Yields," Journal of Urban Economics, Elsevier, vol. 50(3), pages 537-562, November.
    5. Joel Slemrod & Timothy Greimel, 1998. "Did Steve Forbes Scare the Municipal Bond Market?," NBER Working Papers 6583, National Bureau of Economic Research, Inc.
    6. Merle Erickson & Austan Goolsbee & Edward Maydew, 2002. "How Prevalent is Tax Arbitrage? Evidence from the Market for Municipal Bonds," NBER Working Papers 9105, National Bureau of Economic Research, Inc.
    7. Eric M. Leeper & Alexander W. Richter & Todd B. Walker, 2012. "Quantitative Effects of Fiscal Foresight," American Economic Journal: Economic Policy, American Economic Association, vol. 4(2), pages 115-144, May.
    8. James M. Poterba & Kim Rueben, 1999. "State Fiscal Institutions and the U.S. Municipal Bond Market," NBER Chapters,in: Fiscal Institutions and Fiscal Performance, pages 181-208 National Bureau of Economic Research, Inc.
    9. Anthony M. Diercks & William Waller, 2017. "Taxes and the Fed : Theory and Evidence from Equities," Finance and Economics Discussion Series 2017-104, Board of Governors of the Federal Reserve System (U.S.).
    10. Lorenz Kueng, 2014. "Tax News: The Response of Household Spending to Changes in Expected Taxes," NBER Working Papers 20437, National Bureau of Economic Research, Inc.
    11. Andrew Ang & Vineer Bhansali & Yuhang Xing, 2010. "Taxes on Tax-Exempt Bonds," Journal of Finance, American Finance Association, vol. 65(2), pages 565-601, April.
    12. Pedro Gomis-Porqueras & Solmaz Moslehi & Vivianne Vilar, 2013. "The Fiscal Theory of the Price Level When All Income is Taxed," Monash Economics Working Papers 09-13, Monash University, Department of Economics.
    13. Graham, John R., 1999. "Do personal taxes affect corporate financing decisions?," Journal of Public Economics, Elsevier, vol. 73(2), pages 147-185, August.

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    Keywords

    Forecasting ; Municipal bonds ; Taxation;

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