State Income Tax and Local Government Borrowing Cost Revisited

Theories of the debt market generally suggest that, in states with an income tax, municipal bonds are attractive to investors because the income realized from the bond is exempt from both federal and state taxation. Previous research suggested that borrowing costs in states with no personal income tax are higher because those investments derived no benefit from their exemption from a state income tax. Recent research has questioned whether this is the case. It has also been suggested that, in the case of Texas, borrowing costs are higher than average for a number of reasons other than that state’s lack of a personal income tax. For this study, we analyze a national sample of 1,037 competitively sold issues and find that borrowing costs are, indeed, higher in Texas. Our analysis indicates a smaller effect for the state income tax than was previously thought and suggests that the market is not sensitive to the magnitude of the tax rate.We suggest that recent changes to the bond market have reduced the state income tax effect