Reflections on and Inquiry into Unfamiliar as well as Familar Factors that may Influence the Market for Municipal Bonds

Richard J Cebula

doi:10.52324/001c.7996

Abstract

This study investigates the impact of various factors on the ex-ante real interest rate yield on high grade municipal bonds. The AR/2SLS estimation implies that this ex ante real interest rate is an increasing function of the ex-ante real interest rate yield on thirty-year Treasury bonds while being a decreasing function of net capital flows. The yield in question also is found to have been negatively impacted by the Depository Institutions Deregulation and Monetary Control Act. Furthermore, the estimation finds that this interest rate measure is a decreasing function of the maximum marginal federal personal income tax rate. In addition, it is found that, in the presence of an interaction term, the ex-ante real interest rate yield on high-grade municipals is an increasing function not only of the budget deficit but also the aggregate tax gap. The policy implications of these results include the need to limit the extent of budget deficits and to also limit the extent of income tax evasion in the U.S., lest there will be significant limitations placed on the ability of towns, cities, counties, and states to create new infrastructure in response to changing demographic and economic circumstances and/or maintain existing infrastructure.

Highlights

Pursuant to the ratification of the 16th Amendment to the U.S Constitution on February 3, 1913, The Revenue Act of 1913, implemented on October 3, 1913, legally codified exemption of interest on municipal bonds from federal income taxation
Given the magnitude of this market, as well as the importance of tax-exempt interest rates to city, county, and state governments, this study seeks to identify key factors that influence the level of the ex antereal interest rate yield on high grade municipal bonds, with a focus on potential influences that have been largely or entirely overlooked in the published literature to date, e.g., aggregate income tax evasion and its relationship to the federal budget deficit as well as the budget deficit itself, the Depository Institutions Deregulation and Monetary Control Act of 1980, international capital flows, and alternative measures of income tax rates
This empirical study investigates the impact of various factors on the ex-ante real interest rate yield on high grade municipal bonds, EARTXFREEt, a variable critically important to cities, counties, and states and their infrastructure endeavors

Summary

INTRODUCTION

Pursuant to the ratification of the 16th Amendment to the U.S Constitution on February 3, 1913, The Revenue Act of 1913, implemented on October 3, 1913, legally codified exemption of interest on municipal bonds from federal income taxation. The federal government is precluded from taxing interest on municipal bonds. A multi-trillion dollar market for tax-exempt municipal bonds has evolved over time. Given the magnitude of this market, as well as the importance of tax-exempt interest rates to city, county, and state governments, this study seeks to identify key factors that influence the level of the ex antereal interest rate yield on high grade municipal bonds, with a focus on potential influences that have been largely or entirely overlooked in the published literature to date, e.g., aggregate income tax evasion (measured in this study by the aggregate tax gap) and its relationship to (interaction with) the federal budget deficit as well as the budget deficit itself, the Depository Institutions Deregulation and Monetary Control Act of 1980, international capital flows, and alternative measures of income tax rates. Focusing on high grade municipals creates a high degree of bond quality homogeneity so as to increase confidence in the estimation results because over time the bonds in each year are very comparable to those in each of the other years

BACKGROUND

STUDY OBJECTIVES AND FRAMEWORK

THE EMPIRICAL MODEL AND FINDINGS

CONCLUDING REMARKS