The issue of how taxes affect the prices of assets is an important issue in finance, accounting, and economics. In theoretical models examining the effect of taxes on different assets and different agents (for example, Auerbach and King, 1983; Dybvig and Ross, 1986; Dammon and Green, 1987), taxes induce clientele effects in the asset holdings of agents and the existence of different tax rates affects relative asset prices. In reality, estimating implicit tax rates on assets is more difficult than theoretical models suggest because of the myriad ways the tax code can be distorted, large investor heterogeneity, and the many different degrees of market frictions faced by different investors. These real-world issues are especially true for investigating if the tax rates faced by individual investors, as opposed to the tax rates faced by corporations, affect asset prices because financial markets are often dominated by financial institutions and dealers. For example, studies using equities find little evidence of implicit tax effects (see, among many others, Boyd and Jagannathan, 1994; Fama and French, 1998; Erickson and Maydew, 1998). In Treasury markets, Green and Ødegaard (1993) find that after the 1986 tax reform, the marginal investor in Treasury bonds has a marginal tax rate of zero.
In contrast to government bonds and equities, the municipal bond market is well suited to evaluate how individual tax rates affect asset prices. First, the municipal bond market is large; the Flow of Funds data from the Federal Reserve show that at the end of the first quarter of 2007, there were $2.5 trillion outstanding municipal securities compared to $4.8 trillion Treasuries. Second, municipal bonds are attractive to high net worth individuals. Not surprisingly, individual holdings of municipal bonds dominate the holdings of other corporate entities. At the end of the first quarter of 2007, individuals held 70% of all outstanding municipal bonds. Individuals directly held 36% of all municipal securities outstanding and held 34% through mutual funds, closed-end funds, and other taxable pass-through intermediaries.
Third, individual investors are the marginal pricers in the municipal bond market at an aggregate level, from the fact that the municipal yield curve trades lower than the Treasury yield curve. Short-maturity municipal yields are equal to the Treasury yield times one minus the income tax rate and the ratio between municipal and Treasury yields decreases with maturity. These stylized facts are matched well by Green’s (1993) model, where after-tax yields on municipal and Treasury bonds are equalized by individuals, in contrast to the Treasury market where tax-exempt institutions and dealers dominate pricing. Since at an asset class level individual investors set the prices of municipal bonds relative to Treasury securities, we would also expect individual tax rates to affect the cross-sectional pricing of municipal securities.
It would be impossible to study the effect of individual tax rates in the relative prices of municipal bonds if all municipal securities had identical tax treatment with all cash flows exempt from tax. Fortunately, this is not the case. A unique feature of the municipal bond market is at any given time, an individual investor can purchase municipal bonds which are fully tax exempt, where all the bond cash flows are not subject to tax, or municipal bonds subject to income tax or capital gains tax. Municipal bonds bearing income tax liabilities are termed market discount bonds. We exploit this cross sectional heterogeneity to estimate the effects of individual tax rates on municipal bond prices as well as to characterize how different investor clienteles respond to different tax treatments. Furthermore, the same bond may change its tax treatment over time, changing from say being subject to income tax to becoming fully tax exempt. Thus, we can also identify the effect of taxes from the time series of these bonds as they move across tax boundaries.
The existence of fully tax-exempt bonds together with municipal bonds subject to income or capital gains tax arises from how the tax code defines market discount. When a municipal bond is issued, the coupon payments and original issue discount (OID) are exempt from federal income tax. However, the profits from trading municipal bonds in secondary markets are taxable. If market discount exists, which in most situations is defined as a large enough difference between the market price and par value for a bond issued at par, the purchaser of the bond is liable for income tax, otherwise taxes are levied at capital gains rates. These taxes depend on the purchase price of the bond, the bond’s original issue yield or price, and original maturity. While most municipal bond trades are not subject to tax, there is an important subset of municipal bond transactions involving bonds subject to income tax. In some years trades involving market discount bonds represent over 30% of all transactions.
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