Tax-exempt Market Research Articles

Tax distortions and bond issue pricing

Original issue premium (OIP) bonds are the norm in the US tax-exempt market but very rare in the taxable market. A tax subsidy helps explain this disparity. Unlike bonds issued at par or discount, the price of OIP bonds can fall and yet remain above par, providing secondary market buyers with more tax-exempt coupon and less taxable market discount gain. The subsidy for OIP bonds explains additional, previously undocumented empirical facts. In a calibration exercise, the subsidy’s expected cost to the U.S. Treasury is estimated at $1.7 billion per year.

Borrowing for the Public Good

The importance of tax-exempt borrowing as a capital source to the nonprofit sector has significantly grown over time. Outstanding tax-exempt bonds issued by nonprofits have risen from an inflation-adjusted US$106.3 billion in 1993 to US$388.5 billion in 2010 representing an 8% compound annual growth rate over the period. The increased importance of tax-exempt borrowing relative to other borrowing for nonprofits has gone unnoticed. Here, we ask what factors are associated with this trend. We find wide variation in the increasing use of tax-exempt bond usage between nonprofit sectors. Although nonprofit borrowers other than hospitals have increasingly entered the tax-exempt capital market over the past decade, they still tend to be large organizations with lower risk of bankruptcy or default. Our empirical findings continue to raise the questions that others have raised: How do we make smaller, capital-starved nonprofits better able to take advantage of the tax-exempt market in a responsible manner?

The Cost of Tax Policy Uncertainty

Using the implied marginal forward tax rate and limited empirical data, the author estimates the tax risk premium at roughly 60 basis points, translating into a current market price of tax policy uncertainty of approximately $8 billion per year in the form of a burden imposed on the tax-exempt market. This additional cost also represents potential lost tax revenues to the federal government. The research extracts the market price of tax policy risk embedded in municipal swaps data, using tax-exempt and taxable swap rates. The implied marginal forward tax rate is useful for both municipal finance directors seeking to establish optimal debt policy and researchers seeking to explain the term structure of municipal interest rates. Bond market investors, tax-exempt issuers, and government policymakers may also find the implied marginal forward tax rate useful.

Charity Care by Non-profit Hospitals: The Price of Tax-exempt Debt

In this paper, we study the effects of tax-exempt debt on the supply of charity care of non-profit hospitals. We hypothesize that hospitals using tax-exempt rather than taxable debt are forced to provide higher levels of charity care as a condition for gaining access to the tax-exempt market. The study uses a panel of 189 California non-profit hospitals. Hospital uncompensated care is regressed on the level of uncompensated care by other hospitals in the market, lagged values of tax-exempt and taxable debt and other control variables.The magnitude of the tax-exempt bond subsidy has a positive effect on the flow of charity care and varies positively with the charity care provided by other hospitals. We conclude that subsidies provided by tax-exempt debt are an effective media to increase the supply of charity care by hospitals. Regulators can use competition between non-profit hospitals in order to enforce the desired behavior.

Tax management and investment strategies of property-liability insurers

The Tax Reform Act (TRA) of 1986 reduced the incentives for institutional investors to participate in the tax exempt bond market. This paper develops a model of profit maximization incorporating the TRA provisions applicable to property-liability (PL) insurers. The theory predicts that PL insurers will use underwriting losses to shelter taxable investment income and invest the balance of their portfolios in tax favored securities. Our empirical evidence reveals that insurers continued to invest in tax exempts following the TRA, suggesting that implicit tax rates are low enough to attract insurers into the long-term tax exempt market. However, insurers reduced the proportions of income derived from tax exempt interest and dividends following the TRA.

The Effectiveness of Debt Insurance as a Valid Signal of Bond Quality

The Effectiveness of Debt Insurance As a Valid Signal of Bond Quality The role of private bond insurance in financial markets has generated considerable research (see Cole and Officer, 1981; Braswell, Nosari and Browning, 1982; and Kidwell, Sorensen and Wachowicz, 1987). Previous work focuses mainly on the benefits of insurance to borrowers. This third-party credit enhancement improves the quality of a debt issue and increases its marketability, thereby reducing the borrower's interest cost. However, outside credit assistance is not free. Any interest cost savings due to the purchase of bond insurance must be weighed against the out-of-pocket premium expenses incurred by borrowers. Unfortunately, available empirical studies provide no conclusive evidence as to the net effect of purchasing insurance on bond interest cost. On the one hand, Braswell, Nosari, and Browning (1982) find little or no net benefit to borrowers who use bond insurance. Cole and Officer (1981), on the other hand, report significant net interest cost savings to borrowers as a result of purchasing bond insurance. While the answer to the question of whether a net insurance benefit exist for bond issuers still awaits further empirical investigation, a more fundamental issue deserves attention; What theoretical basis supports the existence of bond insurance? In other words, what induces bond issuers or investment bankers to continue buying debt insurance? In an efficient and competitive market, the premium charged by the insurer should exactly offset any potential interest savings to borrowers from the purcahse of bond insurance. Consequently, no excess or net benefits should exist for borrowers purchasing bond insurance. Thakor (1982) argues that even in an efficient and competitive market, net interest cost savings to borrowers may still exist, due to the signal conveyed by insurance coverage about the default probability of insured debt issues. The signaling hypothesis suggests that, although the direct benefits of bond insurance purchase such as enhanced credit quality and marketability may be offset by the premium incurred, borrowers may enjoy indirect benefits through the signaling function of debt insurance, and this debt insurance signaling provides a basis for a positive net insurance benefit. Kidwell, Sorensen, and Wachowicz (1987) examine the benefits of insurance purchase and attribute the net interest cost savings observed in their data to the signaling function of debt insurance. The signaling argument of debt insurance provides a plausible explanation for why borrowers acquire bond insurance when the market is in equilibrium. Its implication that debt insurance is a valid signal of bond quality in the tax-exempt market, however, is debatable. In the current article, the authors find that complete debt insurance is not an informative signal and the purchase of debt insurance in and of itself cannot provide any signaling benefit to borrowers. (1) Therefore, any net interest cost savings due to the purchase of bond insurance should not be viewed as a result of signaling. Debt Insurance As a Quality Signal Thakor (1982) argues that third-party information producers provide unambiguous signals of seller quality. Such information producers expend resources efficiently to produce information about the quality of a product seller and recover the information production costs by selling their services to the product seller. Investors take the level of services purchased by a seller as a quality signal of the product, and pay a market price that reflects the true quality of the product. Viewing private bond insurers as third-party information producers, Thakor suggests that a property designed premium schedule will induce a borrower to obtain the right amount of insurance coverage which signals exactly the borrower's true probability of default, so that a priori imperfectly informed investors will be well informed in equilibrium. …

The Effects of Statutory Portfolio Constraints on Tax-Exempt Interest Rates: Note

1. lntroduction Whether or not the tax-exempt bond market is segmented is an issue of continuing controversy among academic researchers and market participants. The segmentation issue has been addressed on several levels, including studies of the effects of restrictions on bank entry in the underwriting of revenue bonds, the impact of private purpose revenue bonds on the cost of tax-supported state and local govemment bonds, and the effects of banks and bank demand on yield spreads within the tax-exempt market. Hendershott and Kidwell (1978), in a study particularly relevant for the present one, have offered empirical evidence suggesting that changes in the supply of securities issued by governmental units in one state relative to national new issue volume are associated with systematic changes in relative yields. Other studies (Forbes and Petersen 1975; Kaufman 1976; and Leonard 1983) have called attention to the persistence of yield differentials on tax-exempt bonds that differ only in the state or region of the issuer. While these studies suggest the possibility of geographic or local market segmentation, for the most part there have been few attempts to provide a rationale for the existence of such segmentation. This study attempts to fill the gap by analyzing the effects on tax-exempt interest rates of state laws that regulate both bank portfolio holdings of tax-exempts and the cash management practices of state and local governments (SLGs).

Analysis of the Impact of Capital-Specific Policies or Legislation: Application to Reforms of the Tax-Exempt Market

NUMEROUS GOVERNMENTAL STATUTES AND POLICIES influence the allocation of nonfinancial capital by creating differences in borrowing rates and specifying that income from alternative types of capital be taxed at different rates. For example, borrowing rates paid by states and municipalities are lower than those paid by households and businesses because of the exemption of the interest payments of the former from taxation, and the imputed rent from owner-occupied housing is not taxed at all, while income from corporate capital is taxed at both the corporate and personal levels. The case for favoring particular types of capital is that greater quantities of the favored capital goods (or the lower interest rates for the preferred borrowers) are calculated to provide benefits that outweigh the costs of the favored treatment. Unfortunately, this case is often based on an exaggerated measure of the benefits and an understatement of the costs. The primary source of the miscalculations is the assumption, usually implicit, of unlimited available resources. As a result, more housing or state and local construction or business investment can be obtained without driving up interest rates and crowding out other outlays; in fact, multiplier