An analysis of implied tax rates on long-term taxable and tax-exempt bonds

Abstract

We examine the impact of differences in interest rate volatility, the taxation of capital gains and losses, callability, the Tax Reform Act of 1986, corporate and personal tax rates, and the value of the tax-timing option on the quilibrium yield relationship between long-term tax-exempt and taxable bonds. Tax consequences of each of these factors for investors potentially influence the implied tax rate associated with tax-exempt and taxable bonds. Using monthly data from 1957 through 1988 we estimate time series regression equations that relate the ratio of par yields on 20-year and 30-year tax-exempt and Treasury securities to these tax and volatility factors. The empirical results indicate that (1) increased volatility of municipal yields had a strong, positive impact on the equilibrium yield ratio, (2) changes in marginal personal income tax rates negatively affected the yield ratio; and (3) changes in the Treasury yield curve slope negatively influenced the yield ratio. None of these factors affected the yield ratio differently after 1986.