State Income Tax Changes and the Demand for Municipal Bond Funds
47 Pages Posted: 17 Sep 2020 Last revised: 18 Mar 2021
Date Written: February 23, 2021
We consider how state income tax changes affect the demand for municipal bonds by in-state investors. A tax increase (decrease) makes investing in municipal bonds more (less) desirable, and theory predicts a change in demand by investors until the yields on municipal bonds reach a new equilibrium. Using a sample of state-specific municipal bond funds, we find states with tax decreases have net outflows in the following year of approximately 2% per percentage point drop in tax rates, while tax increases lead to inflows around 1.58%. We find that the response to tax changes is not the immediate reallocation predicted in perfect markets with no frictions.
Keywords: municipal bonds; mutual funds; bond funds; state income tax
JEL Classification: G11; H24
Suggested Citation: Suggested Citation