TAX EFFECTS, THE TAXABLE TAX-EXEMPT YIELD SPREAD, AND TAX-REFORM 1986

Investors and economists have long believed that personal income tax rates influence the yield spread between taxable and tax-exempt bonds. Yet, the empirical evidence in support of this financial axiom is mixed. This article investigates the existence of tax effects in the yield spread between corporate and municipal bonds within the context Of a structural model of the demand for and supply of such bonds. A weighted average marginal tax rate on personal income is used to capture the effects of changing personal income tax rates on the yield spread. The results of this article suggest that personal income tax rates and the Tax Reform Act of 1986 have had a pronounced effect on the municipal market and the yield spread.