Determination of Tax Effects in the Yield Spread Between Taxable and Tax-Exempt Bonds.

Abstract

Investors and economists have long believed that personal income rates influence the yield spread between taxable and tax-exempt bonds. The empirical evidence in support of this financial axiom is scant, however. This thesis investigates the existence and magnitude of tax effects on the yield spread between corporate and municipal bonds within the context of a structural model of the dem and for the supply of such bonds. Previous studies of yield spread determination have relied on the use of an unrestricted reduced form estimation procedure, and have often assumed exogenous security supplies. Assuming that bond prices are determined by the interaction of buyers and sellers in the marketplace, the methodology adopted in this paper is theoretically appropriate and provides certain statistical advantages. A correctly specified model produces more efficient reduced form estimates than the more common unrestricted approach. Moreover, the explicit estimation of the equations for the supply of bonds avoids the simultaneous equations bias problem that may arise in an unrestricted equation with exogenous security supplies. The structural model of the dem and for and supply of corporate and municipal bonds is estimated using both a Two Stage Least Squares (TSLS) and a Full Information Maximum Likelihood (FIML) procedure. Under TSLS, the derived reduced form equation for the yield spread reveals that personal income tax rates have a pronounced effect on the yield spread and suggests an elasticity value of almost one. Other dem and and supply variables appear to have a statistically significant effect on the yield spread--although the influence of some, such as the level of financial institution profits, is smaller than anticipated. The FIML estimates appear markedly different from those of the TSLS procedure, but are deemed less reliable since the results of a Likelihood Ratio test for over-identifying restrictions indicates that the model is mis-specified.