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Arbitrage and the Savings Behavior of State Governments

  • Metcalf, Gilbert E

The federal tax code creates strong incentives for tax arbitrage 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 seven 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. Copyright 1990 by MIT Press.

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Article provided by MIT Press in its journal Review of Economics & Statistics.

Volume (Year): 72 (1990)
Issue (Month): 3 (August)
Pages: 390-96

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Handle: RePEc:tpr:restat:v:72:y:1990:i:3:p:390-96
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  1. Hausman, Jerry A. & Taylor, William E., 1981. "A generalized specification test," Economics Letters, Elsevier, vol. 8(3), pages 239-245.
  2. 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.
  3. 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.
  4. Metcalfe, G.E., 1988. "Federal Tax Policy And Municipal Financial Behavior," Papers 29, Princeton, Woodrow Wilson School - Discussion Paper.
  5. 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.
  6. J. Richard Aronson & James R. Marsden, 1980. "Duplicating Moody's Municipal Credit Ratings," Public Finance Review, , vol. 8(1), pages 97-106, January.
  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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