The effect of tax rate changes on the yield spread between corporate and municipal bonds

Abstract

This study examines the effects of personal and corporate tax rate changes on the spread between pre-tax corporate bond yields and municipal bond yields, and provides evidence of tax clientele differences across bonds of different maturities and across bonds of different risk levels. Implicit tax theory suggests that the personal and corporate tax rate reductions of ERTA and TRA86 should reduce the yield spread between corporate and municipal bonds. The sample consists of 2,770 newly-issued taxable corporate bonds over the period 1979–1989. Each corporate bond issue is matched with a similar municipal bond issue. The implicit tax rate (ITR) is used to measure the spread between corporate and municipal bond yields, and is equal to the yield spread divided by the corporate bond yield.For the, full sample, reductions in the personal and corporate tax rates both decrease ITR. However, the results differ across tax regimes. prior to TRA86, changes in the personal and corporate tax rates have similar effects on ITR. Subsequent to TRA86, changes in the personal tax rate become more important and have a greater effect on ITR than changes in the corporate tax rate. The sample is also divided across time-to-maturity (short/long) and risk level (low/medium). Evidence suggests that: (1) prior to TRA86, the marginal investors in medium-risk, short-term bonds were corporations, while the marginal investors in low-risk, short-term bonds were both individuals and corporations; (2) prior to TRA86, the marginal investors in long-term bonds were both individuals and corporations, regardless of risk level; and (3) subsequent to TRA86, the marginal investors in both short-term and long-term bonds are individuals, regardless of risk level.

Citation

Plummer, E. (2002), "The effect of tax rate changes on the yield spread between corporate and municipal bonds", Advances in Taxation (Advances in Taxation, Vol. 14), Emerald Group Publishing Limited, Leeds, pp. 271-307. https://doi.org/10.1016/S1058-7497(02)14014-2