The Influence of Income Tax Rates on the Market for Tax-Exempt Debt
36 Pages Posted: 17 Aug 2009 Last revised: 4 Mar 2010
Date Written: August 16, 2009
Based on the indirect arbitrage opportunities afforded citizens by tax-exempt debt issue, this article presents a model establishing equilibrium in the market for tax-exempt debt. The model yields two predictions. Increases in Federal income tax rates increase the spread between taxable and tax-exempt interest rates, but have no effect on the equilibrium quantity demanded and supplied of tax-exempt debt. The latter prediction contrasts with a conventional point of view that increases in tax rates increase demand and supply of tax-exempt debt. The model’s predictions are supported by empirical evidence.
Keywords: tax-exempt debt, indirect arbitrage, state and local government, Wyden-Gregg Tax Act
JEL Classification: H71, H72
Suggested Citation: Suggested Citation