Municipal Debt and Marginal Tax Rates: is There a Tax Premium in Asset Prices?

Abstract

We study the marginal tax rate incorporated into short-term tax-exempt municipal rates using a unique new data set from the municipal swap market. By applying an affine term-structure framework, we are able to identify both the marginal tax rate and the credit/liquidity spread in one-week tax-exempt rates. Furthermore, we obtain maximum likelihood estimates of the risk premia associated with these variables. The average marginal tax rate during the sample period is 41.6 percent. We find that the marginal tax rate is significantly positively related to returns in the stock and bond markets. The risk premium associated with the marginal tax rate is negative, consistent with the strong contracyclical nature of aftertax fixed-income cash flows which increase in bad states of the economy as personal income and the effective marginal tax rates applied to those cash flows decline.