Heterogeneous Taxes and Limited Risk Sharing: Evidence from Municipal Bonds

Abstract

We evaluate the impacts of tax policy on asset returns using the U.S. municipal bond market. In theory, tax-induced ownership segmentation limits risk-sharing, creating downward-sloping regions of the aggregate demand curve for the asset. In the data, cross-state variation in tax privilege policies predicts differences in in-state ownership of local municipal bonds; the policies create incentives for concentrated local ownership. High tax privilege states have muni bond yields that are more sensitive to variations in supply and local idiosyncratic risk. The effects are stronger when local investors face correlated background risk and/or diminishing marginal non-pecuniary benefits from holding local assets.

Keywords: Taxes, government debt, municipal bonds, segmentation, ownership, clientele effects, public finance, political risk

JEL Classification: F30, G12, G15, H63