STATE TAXATION OF INTEREST INCOME AND MUNICIPAL … · NIC. He used a dummy variable to dis-that...

STATE TAXATION OF INTEREST INCOME AND MUNICIPALBORROWING COSTS***

MARY E. LOVELY* AND MICHAEL J. WASYLENKO*

ABSTRACT effect for small issues only (Kidwell, Koch,

This study uses a sample of individual and Stock, 1984), another found no sig-

municipal bonds to estimate the effect of nifcant effect for large issues (Kidwell,

state exemption of municipal bond interestKoch, and Stock, 1987), while a recent

income on the yield to maturity offered by study found a significant effect for issues

public issuers to finance their debt. Theof any size (Brucato, Forbes, and Leonard,

estimated average effect of a one percent-1991). Moreover, none of the studies find-

age point reduction in the state income tax ing a link between state tax treatment and

rate on in-state municipal bond interest isborrowing costs addresses the question of

a 3.9 basis point reduction in the yield towhether the estimated interest savings are

maturity. A state-by-state comparison ofof sufficient magnitude to outweigh the

interest savings to estimated revenue loss state revenue foregone by the exemption.

on a hypothetical $1 million serial bond This study estimates the effect of the

suggests that aggregate savings arestate tax exemption of in-state municipal

achieved by an exemption policy only ifbond interest income on yields to matu-

more than half of state debt is heldby rity and on state revenue losses. The es-

nonresidents.timates of the effects on yields are de-rived from a random sample of 1443 serialissues and their component bonds issuedduring the January, 1982 to June, 1990

HIRTY-THREE states and the Dis- period. Unlike most previous studies,Ttrict of Columbia levy an individual which do not use individual bonds, our in-income tax and exempt from taxation interest savings estimates are based on anterest income earned on bonds issued by analysis of the yield to maturity offeredgovernmental units located within their on individual bonds within the serials. Inborders, while taxing interest earned on contrast, most studies have analyzedother municipal securities. Such an ex- variations in an aggregate interest mea-emption results in a loss of state revenue. sure, net interest costs (NIC).' Our dataThe justification for this "tax expendi- also span the time period of the Tax Re-ture" is the belief that it results in lower form Act of 1986 (TRA86), which has sig-borrowing costs for in-state issuers. The

nificantly affected the municipal bondreasoning is that state residents will ac-

market.cept a lower yield on in-state securities

We begin with a review of existingbecause of the state income tax exemp- studies of the effect of state income tax-tion than they will accept on taxable, out-

ation on municipal borrowing costs. Thisof-state securities. The prevalence of state

review is followed by a discussion of theexemptions for in-state municipal income

theoretical foundation for the study andsuggests that this reasoning is widely ac-cepted by state policymakers. the derivation of our estimating equation.

Surprisingly, the empirical literature Next we describe the sample of individual

testing the hypothesis that state tax rules bonds created for this estimation and the

affect state borrowing costs provides less tax data used. We then present our

than resounding support for the belief that regression results and their implications

an exemption reduces public-sector inter- for borrowing costs. In a concluding sec-

est rates. An early study found no link tion, we offer estimates of state-by-state

between exemption and borrowing costs interest savings and revenue losses and

(Leonard, 1983), one found a significant we discuss the possibility that municipalbond interest exemptions produce net

*Syracuse University, Syracuse, NY 13244-1090. savings.

37

38 NATIONAL TAX JOURNAL [Vol. XLV

Previous Studies of State Taxation A recent study by Brucato, Forbes, andand Borrowing Costs Leonard (1991) used similar methods to

those of Kidwell, Koch, and Stock (1984),There are relatively few studies of the .effect of state tax treatment on borrowing including the use of NIC as the dependent

costs. Leonard (1983) performed regres- variable. However, Brucato, Forbes and

sion analysis on a sample of new issue Leonard did not restrict their sample to

municipal revenue bonds sold by compet- small bonds only. Their sample consisted

itive bid between 1973 and 1976 inclusive of a pooled cross-section, time-series of se-

to determine the factors influencing the rial bond issues sold in 1988. They found

NIC. He used a dummy variable to dis- that the tax exemption had a significant

tinguish between states with preferential effect on NIC, but they did not find sig-

tax treatment of in-state municipal bond nificant differences in this effect for bond

interest income and those without pref- issues of different sizes. They concluded

erential treatment. He found no signifi- that the average reduction in NIC from

cant relationship between the binary in- state tax exemption of in-state municipal

dicator and NIC. bond income was 11.68 basis points.

In contrast to the binary indicator used While these studies have establishedthat state tax rules influence municipal @iin the Leonard study, Kidwell, Koch, and

Stock (1984) included in their regression borrowing costs, the literature is incom

a measure of the tax rate differential f*aced plete for several reasons. First, the theo-

by municipal bond investors in each state. retical model on which these studies rest

The tax differential was specified as the is not well developed. All three studiesdiscussed above argue that state tax dif-difference between the effective marginal

income and property tax rates on bonds ferentials affect bond yields because

issued outside the state minus the corre- investors compare after-tax yields on bonds

sponding rate on bonds issued in-state. The issued within the state to those issued

sample contained serial bond issues of less outside the state. This investor arbitrage,

than $5 million in value and sold in 1980. however, is not used directly in any of

Kidwell, Koch, and Stock found that tax these studies to develop an estimating

treatment of municipal bond interest in- equation.

come had a significant effect on NIC. They A related issue is that the logic of the

concluded that the tax exemption reduced investor arbitrage model suggests that theyield differential that will reflect taxthe NIC on small municipal bond issues

2 treatment is the yield as seen by inves-by an average of almost 14 basis points. IIn Kidwell, Koch, and Stock (1987), yield x;ors, which is the yield to maturity on a

to maturity rather than NIC was used asparticular bond within a serial rather thanthe NIC. NIC is a measure of the return

the dependent variable in a regression to the investor plus the compensation toanalysis of the determinants of bond yields. the underwriter. This mix sullies tests ofThe sample contained bonds sold during behavioral hypotheses as it is impossiblethe period 1978 through 1980. The unit of to discern whose behavior has generatedobservation was a bond within a serial is- the observed relationship. Further, the usesue and the researchers estimated the ef- of NIC precludes testing whether the ef-fect of state tax differentials separately fect of a tax differential varies with afor bonds with one, ten, and twenty years bond's term to maturity.' Despite the va-to maturity. They found that state tax riety of bonds within a serial, only one ofdifferentials significantly affected bond the four studies Cited above uses yield toyields for the full sample but tax differ- maturity as the dependent variable in theentials were not statistically significant regression analysis.determinants of yields when only large A final limitation of the existing liter-(issue size of $15 million or more) bonds ature is that the only study that used in-were included in the sample. The authors dividual bonds as the unit of observationdid not summarize the issuer cost savings relies on a sample drawn from a rela-implied by their analysis. tively narrow time frame. Significant de-

No. 11 TAXATION OF INTEREST INCOME 39

velopments in the bond market have oc- duces segmentation of investors by taxcurred since then, most notably the Tax rate, with the wealthiest investors hold-Reform Act of 1986 (TRA86), which af- ing riskless municipal debt.fected the municipals market in a variety State exemption rules can be added toof ways.' this three-asset model by noting that

The current study builds on the pre- investors holding municipal securitiesvious literature to offer new estimates of must choose between bonds issued by ju-the interest cost reduction resulting from risdictions within their state of residencepreferential treatment of in-state interest and bonds issued by jurisdictions outsideincome. The study relies on asset market the state. If the state exempts from in-equilibrium for its theoretical foundation come taxation interest earned on in-stateand the basis for the estimating equation. bonds, the most heavily taxed investorsBecause of this foundation and the other will prefer in-state bonds. There are twoconsiderations cited above, the empirical possible outcomes for the interest rate ju-analysis focuses on the yield to maturity risdictions in the exempting state mustof individual bonds rather than the NIC pay to finance their borrowing. If the stockof a serial bond issue. The bonds used in of in-state bonds available to the publicthe analysis are drawn from a random can be financed by the wealth of in-statesample of serial issues sold during the pe- investors willing to hold municipal secu-riod January, 1982 through June, 1990, a rities, then the interest differential be-period of analysis spanning TRA86. tween in-state and out-of-state bonds will

be determined by the tax rate of the

Using Asset Market Equilibrium to investor indifferent between these two as-

Specify An Estimating Equation sets. This outcome results in borrowingcosts for in-state jurisdictions below those

The theoretical model posits individu- of states that do not offer a tax exemp-als as the determining agents in the mu- tion. In contrast, if the state's debt avail-nicipal bond market and stresses the role able to its residents exceeds their wealthof personal income taxes in determining allocated to state municipal bonds, theasset market equilibrium.' The model is state's jurisdictions must attract non-res-based on that of Auerbach and King ident investors who would typically pay(1983), who formally analyze investors' tax on the interest, and thus the state mustportfolio choice when investors cannot offer a higher return.borrow at the tax-exempt rate. The model To develop an estimating equation, weconsiders stocks of three types of assets: link the equations that define the bound-corporate debt, corporate equity, and mu- aries of the various tax clientele. Corpo-nicipal debt. Equilibrium in the asset rate debt, the most heavily taxed asset,market occurs when investors willingly and corporate equity, the next most heavilyhold the outstanding stocks of securities. taxed asset, are sold in national marketsWithout uncertainty and, hence, with no and held by investors in every state.need to diversify, an investor will hold only Investors in corporate debt will have com-that asset with the highest after-tax re- bined federal and state tax rates less thanturn. For investors with the lowest mar- or equal to those of the marginal debtginal tax rates, the preferred asset is cor- investor, for whomporate debt, which is the most heavilytaxed asset but which offers the highest R(l - M*)(1 - S*)return to them on an after-tax basis. Asecond group of investors, with higher R@(1- M@*)(1- Se*) (1)

marginal tax rates, will prefer corporateequity to corporate debt, for it offers them where R (Re) is the before-tax yield onthe highest after-tax return. Finally, corporate debt (equity), M* (Me*) and 8*investors with the highest marginal tax (Se*)are federal and state interest incomerates will prefer municipal securities. The (equity) tax rates as faced by the mar-Auerbach-King model, therefore, pro- ginal debt investor. This marginal debt


investor may live in any state. and various tax rates:Investors with marginal tax rates higher

than those of the marginal debt investor Rmprefer corporate equity to debt, becauseequity is more lightly taxed. The mar- (i - M*)(i- S*)(i- M: s@ s@ut)

R.ginal equity investor is indifferent be- (i - M.*)(i- SO*)(i- S**)(I- 0.)tween holding equity and federally tax- (4)exempt municipals. For the marginal eq-uity investor, This equation cannot be used immedi-

ately as the basis of an estimating equa-tion because the single- and double-starred

Re(l - Me**)(1 - Se**) = Rm(l - S**) (2) tax rates are those of unidentified inves-tors who may reside in any state. Only the

where Rn is the yield on municipal bonds SI's refer to rates levied by the exempting

and the double-starred tax rates are those state.

of the marginal equity investor. The groupThe theory implies that the single- and

of investors with tax rates between thosedouble-starred rates refer to market con-

of the marginal equity investor and theditions faced by any issuer entering the

marginal debt investors hold the out-market. Thus, these rates vary over time,

standing stock of equity. All public is- as tax schedules and market conditions

suers in all states face these national change over time, but they do not vary

markets.across states. Because state-by-state vari-

State-specific assets are available to ation is absent, we can capture the influ-

investors who reside in a state that ex- ence of the corporate debt and equity

empts from taxation interest income markets on municipal yields, including

earned on bonds issued within its borders. federal and state tax rates on these as-

The model suggests that state tax rules sets, through the use of variables de-

affect local borrowing costs if the mar-signed to control for influences that vary

ginal investor in municipal debt issued over time only.

within the state resides in the state. This Equation (4) is linear in logs and sug-

marginal municipal investor is the inves- gests an estimating equation of the form:

tor indifferent between bonds issued out-side the state and those issued within the logRLt = PilogRt + P2109(l - S.ut)t

state. For the marginal municipal inves--

n

tor residing in state j, + P3109(l - &@.)t + PiTIAEit

+ (5)R. (1 - Sout) = P4.(l - 19@n) (3)

where the Pi are estimated coefficients,

where Pvl is the yield on municipal bonds TIMEit is a series of binary variables

issued in state j, 9.1,t is the tax rate on specifying time, and Ot is a normally dis-

out-of-state interest income levied by state tributed disturbance of zero mean. Thej, and Sl,, is the tax rate on in-state in- theory suggests that P, and P2 are posi-

terest income levied by state j. If the state tive, P3 is negative, and P2 = - P3- If theexempts in-state interest from taxation, marginal investors in every state pur-

S,@ = 0. On the other hand, if the state chase in-state bonds, all three parameters

exempts or taxes at the same rate income will have a unit absolute value.

earned on in-state and out-of-state mu- The estimating equation is based on

nicipals,, equation (3) collapses to the con- investors' comparisons of the yield on al-

dition l@n = R,. ternative assets. Thus, we use the yield toUsing (1), (2), and (3), we obtain an maturity on individual bonds as the de-

expression for the in-state municipal yield pendent variable in (5) rather than a

as a function of the yield on corporate debt combined measure of issuer's interest cost


for all of the bonds in the serial. The @pec- Other states do not tax municipal bondification of the tax rates, &.,t and gi., is interest income from any source, includ-not straightforward because the identity ing states that do not levy an income tax.of the marginal municipal investor is un- Among this group is the state of Texas,known. We try several specifications of the which contributed the largest number ofindividual tax variables as reported be- bonds, 191, to the sample. The samplelow. contains no observations from the states

of Alabama, Nebraska, and Kentucky and

Bond Sample Data and Tax Rates none from the District of Columbia. Fromthe sample of serial issues, we obtain a

The estimating equation calls for the use total of 4606 individual bonds.of yield to maturity as the measure of re- In addition to yields, the estimationturn on municipal securities. A yield to procedure requires tax rate informationmaturity is calculated routinely by unfor the marginal investor in municipalderwriters for each bond in the serial when bonds. The strategy we use is to specifya new municipal issue is brought to mar- several sets of tax rates, each set definedket and these yields are reported in The by a different assumption about the iden-Bond Buyer. We drew a sample of new se- tity of the marginal investor. We thenrial issues from The Bond Buyer; the compare the empirical results obtainedsample was designed to be representative using the different tax rate data. In de-of transactions throughout the period veloping the tax rate data, we use the ratesJanuary, 1982 to June, 1990. The sample applicable to married investors living incontains only those new debt issues that a one-wage-earner household. In all cases,(a) are backed by the taxing power of the we account for the deductibility of stateissue, although not always the full faith income taxes paid against federal in-and credit, (b) are larger than $1 million come.'1982 dollars in value, (c) were competi- Three sets of tax-rate data were devel-tively bid, (d) have yields to maturity re- oped based on alternative assumptionsported, and (e) have fixed coupon rates. about taxable income. The first set of taxFrom the debt issues included in the sam- rates uses the maximum federal incomeple, we recorded information on the serial tax rate and the maximum state incomeissue itself and on the characteristics of tax rate. A second set of tax rates wasbonds with terms of approximately 1, 5, created using the state and federal mar-10, 15, 20, 25, and 30 years. ginal personal income tax rates at an in-

The sample contains a total of 1443 se- come of $40,000 in 1983, with the incomerial issues, including issues brought to level adjusted by the Consumer Price In-market during every month within the dex (CPI) for other years. We chose $40,000analysis time frame. Because of the lo- because information from the Survey ofgistics required to obtain the sample, we Consumer Finance revealed that in 1983were not able to stratify the sample by about 99 percent of non-retired house-state.6 Consequently, states with jurisdic- holds holding municipal bonds in theirtions that enter the bond market fre- portfolio had annual incomes of $40,000quently appear frequently in the sample. or more. A third set of tax rates was cre-While the number of serial issues in the ated using household income of $20,000sample.from each state varies widely in 1983. The Survey of Consumer Financeamong states, we have many observa- revealed that in 1983 non-retired house-tions from states that treat municipal bond holds holding municipal bonds had in-interest income in ways other than the come as low as $20,000 to $21,000. In cre-exemption of in-state interest income only. ating this third set of tax rates, we choseSome states tax interest income from all rates appropriate for a household withmunicipal securities, including those taxable income of $20,000 in 1983, withoriginating within the state. This group the income level adjusted by the CPI forincludes the state of Illinois, which con- 1982 and subsequent years.tributed 61 serial issues to the sample. The mean 1982 marginal tax rates af-


ter federal deductibility for states that Other Control Variableshave a personal income tax are 4.1 per- The theoretical model abstracts fromcent at the maximum, 4.6 percent at other aspects of bonds and relates munic-$40,000, and 5.0 percent at $20,000. The ipal bond yields to the corporate interestsharp reduction in marginal federal tax rate and state income tax rates. A ran-rates and changes in state rates during domly-chosen sample of municipal bondsthe 1980s results in comparable mean tax exhibits variation in a number of otherrates for 1990 of 5.0, 4.8, and 4.4 percent, important characteristics. Thus, we in-respectively." The tax rates are highly clude in our analysis variables to controlcorrelated. For example, the correlation for this variation in bond characteris-coefficients between the state maximum tics.10marginal tax rates and the tax rates at The first of these variables indicates thethe $40,000 and $20,000 income levels are value of the serial bond issue, deflated so0.85 and 0.82, respectively. The correla- that all values are in constant 1982 dol-tion coefficient between the tax rates at lars and then transformed into naturalthe $40,000 and $20,000 income levels is logs. Our theory provides no prediction for0.98. the sign of the effect of size on yield. The

The estimation procedure also requires second variable for the serial issue indi-data on the state's tax treatment of mu- cates the presence of a limitation on thenicipal bond interest income earned on in- use of taxation to repay the debt. We ex-state and on out-of-state securities. To de- pect that relative to full-faith-and-credittermine these rates, we used information, debt, bonds backed by limited tax powerbased primarily on Public Securities As- will pay higher yields. Therefore, we ex-sociation (1987), on state rules regarding pect the sign of the tax-power coefficientthe taxation of interest income. Most states to be positive.exempt from the personal income tax in- The third variable included indicates if

terest paid to residents of the state on in- a bond is "bank-qualified." Under TRA86,

state municipal bonds. Of the states that banks may deduct from federally taxablehave a personal income tax, Illinois, Iowa, income 80 percent of interest payments

Kansas, Oklahoma, and Wisconsin tax on deposits backed by bonds designated

residents on the interest earned on in-state as bank-qualified." Because this desig-

municipal bonds. Most states tax their nation makes a bond more desirable to

residents' interest earnings on bonds is-banks we expect it to reduce the supply

sued within other states. Of states havingof suc@ bonds available to the household

a personal income tax, California, Indi- sector. Thus, we expect bank-qualified

ana, New Mexico, Utah, Vermont andbonds to have lower yields and the coef-ficient of the bank-qualified indicator to

Washington exempt residents from pay- be negative.ing tax on all municipal bonds. The fourth serial variable is a binary

Estimation also requires a measure of variable indicating whether or not thethe before-tax return on corporate debt (R)- bond is insured. We expect insurance toGiven that the yield on corporate debt de- reduce the yield investors require to holdpends on its term to maturity, we seg- a bond, so the prediction is that the signmented our sample by term to maturity of the estimated insurance coefficient willand we chose an interest rate index be negative. The last serial variable in thematching the term of the municipal bond analysis identifies the number of bidssubsample. The interest rate variable is submitted by underwriters during thean index of six-month CD rates for the One- competitive bidding process. Previous re-year bond sample, a medium-term AAA search suggests that a larger number ofcorporate bond index for the 5-, 10-, and bids are associated with greater effort by15-year samples, and a long-term AAA underwriters to market the serial issuecorporate bond index for the 20'-year (Kessel, 1971), so we expect the sign of thesample.' bid coefficient to be negative.


We also include variables to control for percent of the one-year bond sample isquality differences among the bonds in the characterized by limitations on the tax-sample. The first of these variables is a ing power of the issuing jurisdiction. Thisbinary variable indicating whether or not share rises to 10.6 percent in the 20-yearthe bond is rated by Moody's. The re- sample. Bonds comprising about 22 per-maining variables are a set of binary cent of each sample are bank-qualified.variables indicating the rating of the bond Between 22 and 25 percent of the bondsat the time of issue. The left-out category in the samples are insured. Similarly, be-is the Aaa rating. Bonds rated Aaa are of tween 89 and 94 percent of the bonds inthe highest quality, so we expect the sign the samples have been rated by Moody's,of the rating-indicator coefficient to be with the means for the rating binaries in-negative and the sign of all the rating dicating the distribution of bonds withincategory variables to be positive. We also each rating category. The omitted ratinginclude a set of binary variables indicat- is Aaa. The remaining binary variablesing if the bond is callable, not callable, or indicate callability. The means for "call-call status unknown. Because calls sub- able" show that less than 1 percent of theject the investor to reinvestment risk, we one-year bonds are callable prior to ma-expect callable bonds to command a pre- turity, but that 46.6 percent of the bondsmium. in the 20-year sample are callable. "Call

The analysis also includes a measure of unknowre' indicates that we have no in-the net debt outstanding from all public formation about the call status of approx-issuers within the state expressed as a imately 30 percent of the bonds in eachportion of state personal income per cap- sample. The average size of the bonds, inita. This variable is a proxy for the stock 1982 dollars, ranges from $9.3 million forof in-state debt relative to the wealth of the 5-year sample to $15.5 million for thein-state investors. A larger relative stock 20-year sample. The final non-tax explan-of state debt may require issuers to at- atory variable measures the indebtednesstract investment by state residents with of the state issuing the debt representedsmaller marginal tax rates, thereby rais- by the bonds within each sample. Theing in-state yields. Thus, we expect the bonds in the five samples, on average, havesign of the estimated coefficient to be pos- associated relative debt levels of 20 per-itive. cent.

The bid variable measures the number

Regression Results of bids received by the issuer during thecompetitive bidding procedure. The av-

Table 1 provides means for each of the erage number of bids received for bondsnon-tax explanatory variables used in the in each sample is about 4.4. We were un-regression analysis. The first row pro- able to obtain information on the numbervides the average yield to maturity for of bids received for every issue. We be-each of the five samples. The average yield lieve the pattern of missing data is ran-rises as the term to maturity rises. In dom and, thus, we filled in missing datacontrast, the average taxable yield does using the average of the bid variable fornot follow a monotonic pattern across the each sample.5'-, 10'- and 15-year samples, for which it In performing the regression analysis,is a medium-term AAA corporate bond we also included a series of binary vari-index. Differences in the mean across these ables to capture fixed effects over time. Usesamples reflects differences in the time of of time dummies was indicated by theissue of bonds within each sample. theory. They also improve estimating ef-

A large number of the explanatory ficiency with time-series data and ac-variables used in the regression analysis count for changes in federal tax rates dur-are binary variables that indicate the ing the 1982 to 1990 period. Two types ofportion of the sample having a particular time dummies are included in each equa-characteristic. Looking across the second tion. The first set captures year effects,row of Table 1, we see that less than nine comprising eight binary variables. The


TABLE I

MEANS FOR NON-TAX VARUBLES USED IN REGRESSION ANALYSIS,BY TERM TO MATURITY

Term-to-Maturity

Variable I Year 5 Year 10 Year 15 Year 20 Year +

Yield (percent) 5.712 6.907 7.771 8.230 8.446

Taxing Power 0.087 0.079 0.078 0.090 0.106

Bank-Qualified 0.220 0.228 0.222 0.232 0.211

Imured 0.227 0.227 0.237 0.250 0.246

Number qf Bids 4.542 4.641 4.592 4.385 4.393

Rated 0.944 0.921 0.922 0.908 0.887

Aal 0.030 0.030 0.031 0.039 0.051

Aa 0.154 0.134 0.140 0.144 0.175

Al 0.144 0.151 0.145 0.133 0.111

A O.Z40 0.230 1 0.219 0.187 0.140

Baal 0.048 0.046 0.046 0.042 0.038

Baa 0.031 0.037 0.039 0.042 0.047

Ba 0.001 0.001 0.002 0.002 0.002

Callable 0.006 0.016 0.218 0.464 0.466

Call Unknown 0.294 0.309 0.298 0.308 0.361

Corporate yield (percent) 8.860 10,310 10.290 10.190 10.563

Real issue size 9.962 9316 9.640 11.317 15.524

Deb Vbcome 0.193:t@@0-198--, 0.199 0.200 , 0.200

second set of dummies contains interac- sample share a serial with one or moretions between month indicators and the bonds, resulting in 39 binary variables.year binaries. For longer term bonds (20 +), Table 2 provides the means of the taxa third set of dummy variables was in- variables used in the analysis. The meancluded in the equation and needs special maximum state and local individual taxmention. The number of bonds in the 20, rate levied on out-of-state bonds ranges25, and 30 samples were small, so we from 3.35 percent for the 20+-year sam-combined them into a 20+ sample. Thus, ple to 3.85 for the one-year sample. Sincein the regression using the 20+-year many states exempt in-state municipalsample, we include a series of binary interest income from taxation, the meanvariables designed to capture correlations maximum rates on in-state interest in-among bonds taken from the same serial come are much lower than the maximumissue. Eighty-eight bonds in the 20+ rates on out-of-state interest income,


TABLE2

MEANS FOR STATE AND LOCAL TAX RATES ON MUNICEPAL BONDMUREST, BY TERM TO MANWW

(figures in percent)

Term-to-Maturity

Variable' I Year 5 Year 10 Year 15 Year 20 Year +

Max - out of state 3.847 3.592 3.582 3.650 3.354

Max - in state 0.293 0.332 0.328 0.254 0.144

$40K - out of state 4.070 , 3.831 3.812 3.825 3.472

$40K - in state 0.330 0.376 0.367 0.284 0,156

$20K - out of state 4.610 4.338 4.323 4.321 3.912

$20K - in state 0.345 0.401 1 0.391 0.302 0.173

Out of state refers to the tax rate that applies to residents for interest earned on out-of-state bonds. In state refers to the tax rate that applies to residents for interest earned onin-state bonds.

ranging from 0.14 for the 20+ -year sam- restriction could not be rejected at the 5ple to 0.332 for the 5-year sample. The percent significance level for any of thecorresponding mean rates for taxes at five equations.$40,000 and $20,000 of constant-dollar As expected, a limitation on the taxingincome are slightly higher than those cal- power of the issuing jurisdiction raises theculated using maximum rates, because yield required to sell a bond, as indicatedthese state rates are adjusted for the de- by the positive coefficient. This coefficientductibility of state taxes from federally is significant for every sample, except thetaxable income. In general, this deduc- 20-year sample. If a bond is bank-quali-tion is worth the most to taxpayers in the fled, it is a more attractive asset for a bankhighest federal tax bracket. to hold than are other municipal bonds.

In Table 3 we report regression results As expected, the sign of the bank-quali-using the tax rates calculated at the fled coefficient is negative and it is sig-$40,000 income level. Results obtained nificant for every sample. We expected theusing the other sets of tax rates are sim- sign of the coefficient for the binary vari-ilar. The explanatory variables explain at able indicating that a bond is insured toleast 87 percent of the variation in the log be negative, as other studies have foundof the yield to maturity in each of the five that insurance reduces yield, all else equal.samples. Most of the explanatory vari- The estimated coefficient is positive andables are significant and have the pre- significant for every sample, a finding thatdicted sign, The model specification sug- deserves further attention. Note that thegests that, in the reported regressions, we effect on yield of purchasing bond insur-constrain the coefficients of the in-state ance cannot be discerned from this coef-and out-of-state interest income tax rates ficient alone. Insurance raises the ratingto be equal. To anticipate our results, this a bond receives and thus also affects yield


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through the effect of rating on yield. Af- tween the log of constant-dollar size andter accounting for the higher rating of the the dependent variable in the one-year andinsured bond, investors apparently apply twenty-year samples only. In the threea premium to the yield to account for the larger samples, the coefficient was insig-risk associated with the insurance. Fi- nificant and very small.nally, although there is considerable de- The model suggests that states withbate over why the number of bids affects large debt levels relative to the wealth ofyields, on the basis of previous research state residents will have higher borrow-we expected lower yields to be associated ing cost. Larger debt levels imply that thewith bonds on which many underwriters marginal in-state municipal investor is asubmitted bids. The negative, significant person with a lower state tax rate. Ourcoefficient in all five samples provides results are consistent with this hypothe-further support for the importance of un- sis, as the results for all samples show aderwriter competition. positive, significant relationship between

The negative, significant coefficient on the relative debt of a state's public issuersthe rating indicator in all five samples in- and the yield on bonds issued in the state.dicates that Aaa rated bonds have lower For the tax variables, the model sug-yields than unrated and lower-rated bonds. gests that higher tax rates on out-of-stateThe seven binary variables measure the municipal bond interest income and loweradjustment to the expected yields of bonds tax rates on in-state municipal bond in-when they receive a rating other than Aaa. terest income will lower borrowing costsThe copfficients are larger for binaries in- for in-state issuers. The results from alldicating bonds of lower quality. In partic- five samples are consistent with this hy-ular, yields rise dramatically for bonds pothesis. The tax differential is specifiedreceiving the lowest rating, Ba, which in- as [ln(l - Sout) - ln(l - Sin)]. The esti-dicates that Moody's has determined the mated coefficient on this differential isbond to have speculative elements. The positive and highly significant in all Sam-rating dummies are highly significant in ples. These estimates provide strong evi-all samples. Results for the call status in- dence that the widespread practice of ex-dicators were mixed across samples. In the empting residents from state personalone-year sample, very few bonds are call- income tax on in-state municipal bond in-able and we found no significant relation- terest income significantly reduces mu-ship between call status and yields. De- nicipal borrowing costs. We note, how-spite containing a larger share of bonds ever, that the value of the coefficients onthat are callable, we found no significant the taxable-asset yield index and on therelationship between callability and yields tax differential are significantly differentin the five, ten, and twenty-year samples. from unity."Only in the fifteen-year sample does the A comparison of results obtained usingcallable indicator have the expected sign alternative tax rates is provided by Tableand have statistical significance. Unfor- 4, which presents the effect on yield totunately, further refinement of our call maturity of a one percentage point reduc-status indicators is not possible as many tion in the tax rate on in-state municipalbonds are not recorded in Moody's Mu- bond interest income. Regardless of thenicipal and Government Manual, which is tax variable used in the regression anal-the source of the call data. ysis, the estimated restricted tax coeffi-

Not surprisingly, we find a strong, pos- cients are positive and highly significaLit.--itive relationship between the taxable-as- Differences in the value of the coeffi-set yield index and municipal yields in all cients, however, lead to variation in thefive samples. Less clear are the results for tax-effect estimates shown in Table 4. Thethe size variable. Some previous research pattern of tax effects across the term tohas found a negative relationship be- maturity is the same for all variable spec-tween the size of the serial of which the ifications, with the largest tax effect es-bond is part and the bon&s yield. We found timated for the 5- and 10-year bonds. Av-a significant, negative relationship be- eraging across the term to maturity, the

48 NATIONAL TAX JOURNAL (Vol. XLV

TABLE 4

EFFECT ON BOND YIELDS OF A ONE PERCENTAGE POINT REDUCMON IN THETAX RATE ON IN-STATE MUNICUAL BOND INTEREST INCOM%

BY TERM TO MATURrfr

(in bads points)

Terin to Mattuity

Tax Variable 1 5 10 is 20 Averap

Maximmn rates -2.7 -5.0 -5.0 -43 -4.6 -4.3

$40,OOL)rates -3.8 -4.4 -4.3 -3.3 -3.8 -3.9

$20,OW rates -3.3 -3.9 -3,8 -3.1 -3.4 -3.5

Avemge-aU rates -3.2 -4.5 -4.4 -3.6 -3.9 -3.9

IU tax effect is calculated fiom the logaritbmic specification using the mean of yield to maturity aWtax rate for eacb tenn to maturity.

largest tax effect is obtained using the puted without discounting, a decrease ofmaximum tax rates and the smallest us- 3.9 basis points in the yield to maturitying the $20,000 tax rates. would translate into a larger NIC reduc-

These marginal tax effects, which range tion. Consequently, our estimates suggestfrom -2.7 to -5.0, are directly compa- that the effect of in-state interest exemp-rable to, and substantially larger than, tion is larger than previous estimates in-those obtained by Kidwell, Koch, and Stock dicate.(1987), who estimate marginal tax effectson yields to maturity of 0.5, 1.1, and 1.8

Policy Ibnplicationsbasis points for samples of l-, 10- and 20-year bonds, respectively." To make a The regression results support the viewsimple comparison of the results in Table that exemption of in-state bond income4 to those obtained using NIC as the de- lowers the yield that public-sector bor-pendent variable, we calculated the av- rowers within the state pay to finance theirerage tax effect across all models and debt. This finding raises the question ofterms. The average is 3.9, which suggests whether the cost savings achieved throughthat a one percentage point reduction in lower yields are sufficient to offset thethe state tax rate on in-state municipal revenue loss resulting from the exemp-bond interest income reduces the yield tion. To shed light on this issue, we es-needed to finance a serial issue by about timated the interest savings and revenue3.9 basis points. Kidwell, Koch, and Stock loss experienced by each state that cur-(1984) found that a one percentage point rently exempts in-state municipal bondreduction in the tax differential reduced income from individual income taxationNIC by 3.6 basis points while Brucato, while taxing interest income from otherForbes, and Leonard (1991) found an NIC sources.reduction of 2.3 basis pointS.14 While these In calculating the interest savings re-estimates are "close" to the average of our sulting from exemption, we used theestimates, they refer to a different inter- regression results obtained using theest cost measure and thus they are not $40,000 tax rates, as this specificationstrictly comparable. Because NIC is com- produced the mid-range tax-effect esti-


mates. We calculated the predicted bond caused by the flatness of most states' ef-yield, with and without the exemption, for fective marginal tax schedules. Becausea hypothetical serial issued in June, 1990 of federal deductibility, most states withwith equal portions maturing in 1, 5, 10, graduated schedules levy similar effec-15, and 20 years. State-specific tax rates tive tax rates on households with $40,000and debt-to-income ratios were used. Note annual income as on those at the maxi-that because of the nonlinear specifica- mum. States with high revenue losses totion given by equation (5), the resulting interest savings, such as Louisiana andinterest-cost estimates are nonlinear Ohio, have the most graduated effectivefunctions of state tax rates. marginal tax schedules. This link be-

The first column of Table 5 provides the tween revenue losses and the slope of theestimated yield reduction experienced by effective tax schedule has been noted ateach state because of its exemption rule. the federal level, where compression ofThe largest reductions occur for those marginal tax rates by TRA86 is believedstates with the highest effective tax rates to have reduced the revenue loss attrib-at the $40,000 income level, such as the utable to federal exetption of municipalestimated 30 basis points reduction for bond interest income.'Montana, 26 points for Massachusetts, and We emphasize that these revenue loss24 points for Oregon. The lowest reduc- estimates are based on the assumption thattions occur for states with low tax rates all bonds are held by state residents andat this income level, such as 5 basis points thus would be taxable by the state if ex-for Pennsylvania and 9 points for New emption were repealed. This assumptionJersey. The second column translates these is clearly extreme. Despite the tax advan-basis-point reductions into first-year in- tages of holding bonds issued within one'sterest savings on a $1,000,000 serial. These state of residence, many investors holdsavings range from $3041 for Montana to bonds from other states for diversifica-$543 for Pennsylvania. tion. The loss ratio we computed provides

We also estimated the first-year reve- a rough measure of the share of bonds thatnue loss resulting from the exemption, must be held by nonresidents for states tobased on the assumption that all of the break even on the interest exemption. Forbonds are held by state residents. We cal- most states, the nonresident share sug-culated the revenue losses using the na- gested by the loss ratio as required fortional distribution by income class of mu- breaking-even is 52 percent. However, thisnicipal bond interest income to estimate ratio probably overstates the necessaryan average tax rate by state on the ex- nonresident share. States that repeal theempted interest income." These esti- exemption of in-state interest income aremates are based on the yield, and hence likely to increase the share of their debtinterest income, that would occur without held by nonresidents as yields rise and asan exemption of in-state interest income. residents diversify their holdings. This

The revenue losses in the third column behavior reduces the no-exemption reve-of Table 5 show the largest losses for nue, and thus the revenue loss, loweringMontana and the smallest losses for the nonresident share needed to breakPennsylvania. The pattern across states even.is similar to that found for interest sav- In summary, we have estimated the ef-ings. That such a pattern occurs is not a fect of state tax treatment of municipalnecessary consequence of the method used, bond interest income on public-sector bor-as the interest savings are based on the rowing costs using a large, national sam-$40,000 tax rates while the revenue loss ple of individual bonds. Our findings sug-is based on a weighted average of tax rates gest that on average a one percentagewith the weights determined by the dis- point reduction in the tax rate on in-statetribution of bond holdings. As shown in municipal interest reduces the yield re-the fourth column, the ratio of revenue loss quired to finance public borrowing by 3.9to interest savings is 1.9 for the majority basis points. The estimated interest sav-of states. This similarity across states is ings from exempting states rise nonlin-


TABLE 5

ESTIMATED INTEREST SAVINGS AND REVENUE LOSS ON A $1 MILLIONSERIAL BOND ISSUED IN JUNE 1"0, BY STATE

(2) (3) (4)Estimated Interest Estimated Flrst-Year Estimated Fk*-Year Loss Ratio

Reduction Interest SavieV Revenue Loss (3)/(2)(baSiSDOi,415) (to dodan) (indoran)

Alabama 13 1295 Z454 1.9

Arkansas 18 1811 3421 1.9

Arizona 21 2111 3981 1.9

Colorado 13 1299 2461 1.9

122laware 20 2031 3776 1.9

Georgia 16 1554 2940 1.9

Hawaii 26 2615 4817 1.8

wlbg 22 2167 3949 1.9

Kenwclcv 16 1571 2973 1.9

Louipana 11 1055 2713 2.6

Mame 22 2209 4163 1.9

Maryland 19 1942 3665 1.9

Masschusetts 26 2613 4912 1.9

Mchigan 12 1179 2237

aimesota 22 2229 4337

Doi 13 1291 2"8 1.9

ftssoufi 15 1539 2913 119 1

Montana 30 3041 5533 1.8

Nebra*a 15 1543 2832 1.8-

New Hamoshire 13 1293 2451 1.9

New lersev 9 903 1637 1.8

New York 20 2030 3830 1.9

North Cuolina Is 1811 3421 1.9

North Dakota 10 1018 1789 1,7

Ohio 1 13 1335 3059 2.3 1

Oregon 24 2362 4U6 1.9

Penwvlvania 5 543 1033 1.9

Rhode L-land 17 1682 2943 1.7

South Carolim 18 1823 3444 1.9

16 1552 2938 1.

15 1476

16 1570 3 r 1.9fl


early with state tax rates and vary widely an individual wage earner. In all cases, investors wereby state. The pattern of revenue losses assumed to itemize their deductions. The data to de-

velop the tax rates were taken from U.S. Advisorymatches that of interest savings and the Commission on Intergovernmental Relations, Signif-ratio of losses to savings indicates that icantFeatures of Fiscal Federalism (various issues).about half of a state's debt must be held 8These state personal income tax rates reflect the

by nonresidents for losses to be matched ffet of deductibility of state taxes from federal tax-able income. The federal deduction results in lower

by interest savings. net state and local tax rates at higher income levelsthan at lower income levels.

'For the one-year bond, the interest measure usedENDNOTES is an index of six-month certificate of deposit rates,

computed by the Federal Reserve as an unweighted**We acknowledge the financial support of the average of offered rates quoted by at least five deal-

KPMG Peat Marwick Foundation, Tax Research Op- ers. For the 5-, 10-, and 15-year bonds, the interestportunities Program. We thank Bernard Jump, Doug rate index measures the yield on new, medium-termHoltz-Eakin, and John Yinger for helpful comments, industrial bonds. Salomon Brothers computes the in-Daniel Bernhofen and Stephen Ross for research as- dex using new 10-year, noneallable industrial bondssistance, and Esther Gray and Laura Sedelmeyer for rated Aaa or AAA. For the 20-year and longer bonds,production assistance. We also thank John Petersen the interest rate measures the yield on new, long-termof the Government Finance Officers Association, James industrial bonds. Salomon Brothers computes this in-Dearborn of Moody's Investors Service for assistance dex as it computes the index for medium-term indus-with data collection, and anonymous referees of this trial bonds, except that the long-term bonds are thosejournal. The views expressed in this paper do not rep- maturing in 30 years and noncallable for the first tenresent the views of any of these individuals or insti- years.tutions. 'OThe source of all data pertaining to the charac-

'The yield to maturity is defined as the discount teristics of the serial issues or the bonds drawn fromrate that equates the present value of the stream of these issues, except bond ratings and call status, ispayments received by the investor to the price paid The Bond Buyer. Moody's Investor Services, Inc. pro-for the bond. NIC is the undiscouiited sum of total vided information on the rating of each issue at thepayments due from the issuer plus the difference be- time of issue. We obtained information on call statustween face value and price received, divided by the from Moody's Municipal and Government Manualsum of the amount of bonds outstanding over the time (1990).they are outstanding. As explained elsewhere in the "Bank-qualified debt is goverranental-purpose debttext, there are a number of reasons to prefer yield to of government units expecting to issue less than $10maturity as the basis for testing investors' response million of debt in the calendar year. TRA86 elimi-to tax treatment. nated the deduction for interest payments backing

2 A basis point is 1/100 of one percentage point. other tax-exempt securities purchased after August'Cook (1982) discusses the numerous disadvan- 15,1986.

tages of using NIC to explain (lifferences in bond yields,12 The tax differential coefficients will deviate from

including its lack of provision for discounting. He notes their theoretical values of unity if the marginalthat many of the commonly used regressors refer to investors in some states' securities are not residentsindividual bond characteristics, such as call status, of those states.rather than to the serial issue. '3These figures taken from Table I of Kidwell, Koch,

'Petersen (1987) outlines the expected conse- and Stock (1987).quences of TRA86 for the municipal bond market. "These figures taken from Table I of Kidwell, Koch,

'There are several reasons to believe that individ- and Stock (1984) and Exhibit 4, Equation 1.1 of Bru-uals' demand for bonds influences bond yields. First, cato, Forbes, and Leonard (1991).whatever the past role of bank arbitrage, TRA86 'sthe national distribution by income class of tax-greatly restricted banks' ability to engage in simul- exempt interest income is drawn from Feenberg andtaneous taxable and tax-exempt transactions. Second, Poterba (1991), Table 2. We attribute 14 percent ofdespite the empirical support offered by Skelton (1983) interest income to households at the $20,000 mar-for the bank arbitrage hypothesis, more recent am- ginal tax rate, 13 percent to those at the $40,000 mar-pineal work by Poterba (1986, 1989) and Fortune gnal rate, and the remainder to those at The maxi-@1988) provides evidence that the spread between long- mum state rate. Because federal deductibility flattensterm taxable and tax-exempt yields responds to state graduated income tax schedules, more finelychanges in individual tax rates. These findings sup- graded interest-income distributions do little to theport the testing of a model that posits individuals as estimated revenue losses.the determining actors in the tax-exempt market. 16This point is addressed by Feenberg and Poterba

6For more details on the sampling procedure, see (1991).liovely and Wasylenko (1991).

'We accounted for all income surtaxes in existenceat the state and local levels and other taxes levied on REFERENCESinterest income. We also accounted for communityproperty states, which allow spouses to split income Auerbach, Alan and Mervyn A. King (1983), "Taxa-between spouses and pay a lower marginal rate than tion, Portfolio Choice, and Debt-Equity Ratios: A


General Equilibrium Model," Quarterly Journal of Municipal Revenue Bond Interest Costs," JournalEconomics, Vol. 98, pp. 587-609. of Economics and Business, Vol. 35, pp. 71-82.

Brucato, Peter F., Ronald W. Forbes, and Paul A. Lovely, Mary E. and Michael J. Wasylenko (1991),Leonard (1991), "The Effects of State Tax Differ- "State Tax Treatment of Municipal Bond Interestentials on Municipal Bond Yields After Tax Re- Income and Public Sector Borrowing Costs," Finalform," Municipal Finance Journal, Vol. 12. report prepared for KPMG Peat Marwick Founda-

Cook, Timothy Q. (1982), "Determinants of Individ- tion Tax Research Opportunities Program.ual Tax-Exempt Bond Yields: A Survey of the Evi- Petersen, John E. (1987), "Tax-Exempts and Tax Re-dence," Economic Review, Federal Reserve Bank of form: Assessing the Consequences of the Tax Re-Richmond, pp. 14-39. form Act of 1986 for the Municipal Securities Mar-

Feenberg, Daniel and James M. Poterba (1991), "N%ch keV' (Washington, DC: Govenunent Finance CenterHouseholds Own Municipal Bonds? Evidence from of the Government Finance Officers Association).Tax Returns," National Tax Journal, Vol. 44, Poterba, James M. (1986), "Explaining the Yieldpp. 93-103. Spread between Taxable and Tax-Fxempt Bonds:

Fortune, Peter (1988), "Municipal Bond Yields: Whose The Role of Expected Tax Policy," in H. Rosen (ed.),Tax Rates Matter," National Tax Journal, Vol. 41, Studies in State and Local Public Finance (Chicago:pp. 219-233. University of Chicago Press).

Kessel, Reuben (1971), "A Study of the Effects of - (1989), "Tax Reform and the Market for Tax-Competition on the Tax-Exempt Bond Market," Exempt Debt," Regional Science and Urban Eco-Journal of Political Economy, Vol. 79, pp. 706-738. nomics, Vol. 19, pp. 537-562.

Kidwell, David S., Timothy W. Koch, and Duane R. Public Securities Association (1987), An Investor'sStock (1984), "The Impact of State Income Taxes on Guide to Tax-Exempt Securities.Municipal Borrowing Costs, National Tax Journal, Skelton, James L. (1983), "The Relative Pricing of TaxVol. 37, pp. 551-561. Exempt and Taxable Debt," Journal of Financial

- (1987), "Issue Size and Term Structure Seg- Economics, Vol. 12, pp. 343-356.mentation Effects on Regional Yield Differentials U.S. Advisory Commission on Intergovernmental Re-in the Municipal Bond Market," Journal of Eco- lations, Significant Features of Fiscal Federalismnomics and Business, Vol. 39, pp. 339-347. (Washington, DC: U.S. Government Printing Of-

Leonard, Paul A (1983), "Some Factors Determining fice), various issues.

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