How Do Municipal Bonds Behave without Tax Exemption?

Abstract

This article analyzes an extensive sample of tax-exempt and taxable municipal bonds to better understand how municipals behave without federal tax exemption. The authors find that taxable municipals are issued at higher yields in high state tax jurisdictions and that they are less likely to be issued in these areas and more likely to be issued in those that tax in-state issues. This finding suggests tax premium and market segmentation effects. As state tax treatment becomes more important, these effects may inhibit efficient portfolio diversification outcomes. The authors offer insight into how municipal portfolios and the municipal market behave in the absence of federal tax exemption.