Tax News: Identifying Tax Expectations from Municipal Bonds with an Application to Household Consumption

Abstract

Although theoretical models of household behavior often emphasize scal foresight, most empirical studies neglect the role of news, thereby potentially underestimating the total eect of tax changes. Using novel high-frequency bond data, I develop a model of the term structure of municipal yield spreads as a function of future top income tax rates and a risk premium. Testing the model using the presidential elections of 1992 and 2000 as two natural experiments shows that nancial markets forecast future tax rates remarkably well in both the short and long run. Combining these market-based tax expectations with consumption data from the Consumer Expenditure Survey, I nd that consumption of high-income households increases by close to 1% in response to news of a 1% increase in expected after-tax lifetime income, consistent with the basic rational-expectations life-cycle theory.