| The simultaneous existence of taxable and nontaxable (municipal) bonds in the United States financial markets provides a unique opportunity for studying the impact of taxes on asset values. Very commonly, yields on taxable and municipal bonds are compared to estimate investor tax rates. For example, if a par value taxable bond yields 10 percent, and an otherwise identical municipal bond yields 8 percent, it seems apparent that the implied tax rate is 20 percent; i.e., an investor in a 20 percent bracket would be indifferent between the two bonds. After all, since investors are primarily concerned with after-tax returns, traditional economic theory suggests that market forces should drive after-tax returns into equilibrium and, at the margin holding all else constant, equality. Unfortunately, history shows that theories like this one are not always supported in reality.; We compare the relative yields of taxable and municipal bonds in an effort to derive a new theory of the tax structure of interest rates. The phrase “tax structure of interest rates” refers to the observed downward sloping relationship between tax rates implied by relative municipal and taxable yields and time to maturity. We examine the impact of taxes on relative taxable and municipal bond yields and find that a tax structure of interest rates can appear to exist even when investor marginal tax rates are constant across maturities. As a consequence, the tax rate implied by relative bond yields can substantially and systematically understate the true rate, and the bias increases with maturity and interest rate volatility.; The tax structure of interest rates is a longstanding anomaly in financial economics, and a number of theories have been developed to explain its existence. In this paper we offer a potential solution to the puzzle by showing that, under simple conditions in a world of interest rate uncertainty, relative municipal and taxable yields can produce, significantly downward biased estimates of implied tax rates. Moreover, through the use of numerical simulations and a variety of different interest rate processes, we show that a tax structure of interest rates emerges regardless of assumptions made about the various types of interest rate processes. Furthermore, the numerical simulations confirm that the magnitude of the downward bias in implied tax rates is increasing in maturity and interest rate volatility. Indeed, in the models considered, it is the absence of an apparent tax structure of interest rates that would be anomalous. The main conclusion is that, at least potentially, much (or even all) of the apparent tax structure of interest rates may simply be an illusion. |
