Abstract
The taxation of trading gains and losses on taxable and tax-exempt bonds creates large and distortionary trading incentives. I derive the optimal coupon rate, which minimizes the issuer's cost of capital by maximizing investors' tax arbitrage opportunities. An optimally issued 10-year bond can be worth up to 1.5% more than a par bond, a gain created at the expense of the U.S. Treasury.For tax-exempt bonds, the model predictions conform with several unexplained and poorly documented facts: the frequent issuance of premium bonds, except at very long maturities; issue prices increasing with maturity; and coupons remaining high when yields fall.
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