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Stock-Market Yields and the Pricing of Municipal Bonds

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  • N. Gregory Mankiw
  • James Poterba

Abstract

This paper proposes an alternative to the traditional model for explaining the spread between taxable and tax-exempt bond yields. This alternative model is a special case of a general class of clientele models of portfolio choice and asset market equilibrium. In particular, we consider a setting with two types of investors, a taxable investor and a tax-exempt investor, who hold specialized bond portfolios. The tax-exempt investor holds only taxable bonds, and the taxable investor holds only tax-exempt bonds. Both investors hold equity, and the taxable and tax-exempt bond markets are linked through the equilibrium conditions governing equity holding and bond holding for each type of investor. In contrast to the traditional model, this alternative model has the potential to explain the small observed spread between taxable and tax-exempt yields. In addition, this model predicts that the yield spread between taxable and tax-exempt bonds should be an increasing function of the dividend yield on corporate stocks. Although the substantial changes in the tax code during the last four decades complicate the testing of this model, we find some support for the predicted relationship between the equity dividend yield and the yield spread between taxable and tax-exempt bonds.
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Suggested Citation

  • N. Gregory Mankiw & James Poterba, 1996. "Stock-Market Yields and the Pricing of Municipal Bonds," Harvard Institute of Economic Research Working Papers 1761, Harvard - Institute of Economic Research.
  • Handle: RePEc:fth:harver:1761
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    References listed on IDEAS

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    1. Trzcinka, Charles A, 1982. " The Pricing of Tax-Exempt Bonds and the Miller Hypothesis," Journal of Finance, American Finance Association, vol. 37(4), pages 907-923, September.
    2. Fortune, Peter, 1988. "Municipal Bond Yields: Whose Tax Rates Matter?," National Tax Journal, National Tax Association, vol. 41(2), pages 219-33, June.
    3. Whitney K. Newey & Kenneth D. West, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 631-653.
    4. Poterba, James M., 1989. "Tax reform and the market for tax-exempt debt," Regional Science and Urban Economics, Elsevier, vol. 19(3), pages 537-562, August.
    5. Fortune, Peter, 1988. "Municipal Bond Yields: Whose Tax Rates Matter?," National Tax Journal, National Tax Association;National Tax Journal, vol. 41(2), pages 219-233, June.
    6. 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, vol. 43(4), pages 913-931, September.
    7. Martin Feldstein & Lawrence Summers, 1983. "Inflation and the Taxation of Capital Income in the Corporate Sector," NBER Chapters,in: Inflation, Tax Rules, and Capital Formation, pages 116-152 National Bureau of Economic Research, Inc.
    8. James M. Poterba, 1987. "Tax Policy and Corporate Saving," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 18(2), pages 455-516.
    9. Buser, Stephen A. & Hess, Patrick J., 1986. "Empirical determinants of the relative yields on taxable and tax-exempt securities," Journal of Financial Economics, Elsevier, vol. 17(2), pages 335-355, December.
    10. Green, Richard C, 1993. "A Simple Model of the Taxable and Tax-Exempt Yield Curves," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 233-264.
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    Cited by:

    1. Coronado, Julia Lynn, 1999. "Tax Exemption and State Capital Investment," National Tax Journal, National Tax Association, vol. 52(n. 3), pages 473-82, September.
    2. Shoven, John B. & Sialm, Clemens, 2004. "Asset location in tax-deferred and conventional savings accounts," Journal of Public Economics, Elsevier, vol. 88(1-2), pages 23-38, January.
    3. John B. Shoven & David A. Wise, 1998. "The Taxation of Pensions: A Shelter Can Become a Trap," NBER Chapters,in: Frontiers in the Economics of Aging, pages 173-212 National Bureau of Economic Research, Inc.
    4. 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.
    5. Dinardo, John & Hallock, Kevin F & Pischke, Jörn-Steffen, 2000. "Unions And The Labour Market For Managers," CEPR Discussion Papers 2418, C.E.P.R. Discussion Papers.
    6. John B. Shoven, 1999. "The Location and Allocation of Assets in Pension and Conventional Savings Accounts," NBER Working Papers 7007, National Bureau of Economic Research, Inc.
    7. Graham, John R., 1999. "Do personal taxes affect corporate financing decisions?," Journal of Public Economics, Elsevier, vol. 73(2), pages 147-185, August.
    8. Joel Slemrod & Timothy Greimel, 1998. "Did Steve Forbes Scare the Municipal Bond Market?," NBER Working Papers 6583, National Bureau of Economic Research, Inc.
    9. 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.

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