| Merton Miller, the 1990 Nobel Prize in Economics recipient, suggested that when examining the relationship between taxable and tax-exempt yields of equal maturity, the taxable yield is determined based on the tax-exempt yield which is taken as a given. The taxable yield is "grossed-up" for taxes from the tax-exempt yield to make the yields on these two securities identical on an after-tax basis. An alternative theory is presented where the tax-exempt yield is "discounted" for taxes from some given taxable yield.; Cointegration is used to examine the long-run relationship between taxable and tax-exempt yields of equal maturity. The effects of changes in both corporate and personal tax rates on the relationship between taxable and tax-exempt yields are also examined. When neither yield is adjusted for taxes, there is no evidence of a long-run relationship. When yields are adjusted by the corporate tax rate, one and five year taxable and tax-exempt yields are found to be cointegrated. Five, ten and twenty year taxable and tax-exempt yields are found to be cointegrated when yields are adjusted by the personal tax rate. Error-correction models are used to examine which yield is adjusting and which, if either, can be taken as a given. For all maturities, the evidence suggests that the tax-exempt yield is adjusting to maintain equilibrium. The taxable yield does not appear to be adjusting to maintain long-run equilibrium. This evidence supports the alternative model over the Miller model. |
