Impact of federal income tax rates and government borrowing on nominal interest rate yields on tax-free municipal bonds

Abstract

PurposeThis study investigates the impact of federal income tax rates and budget deficits on the nominal interest rate yield on high-grade municipal tax-free bonds (municipals) in the US. The 58-year study period covers the years 1959 through 2016 and thus is very recent.Design/methodology/approachThe study develops a loanable funds model that allows for various financial market factors. Once developed, the model is estimated by autoregressive two-stage least squares, with a Newey-West heteroskedasticity correction.FindingsThe nominal interest rate yield on municipals is a decreasing function of the maximum marginal federal personal income tax rate and an increasing function of the federal budget deficit (expressed as a per cent of GDP). This yield is also an increasing function of nominal interest rate yields on three- and ten-year treasury notes and expected inflation.Research limitations/implicationsWhen introducing additional interest rates such as treasury bills as explanatory variables, multi-collinearity becomes a serious problem.Practical implicationsThis study indicates that lower maximum federal personal income tax rates and larger federal budget deficits, both act to raise borrowing costs for cities (of all sizes), counties and states across the country. Given the study period of 58 years, these relationships appear to be enduring ones that responsible policy-makers should not overlook.Social implicationsTax reform and debt management need to be conducted in a very circumspect fashion.Originality/valueNo recent study investigating the impact of the two key policy variables in this study has been published.