Default Risk Cannot Explain the Muni Puzzle: Evidence from Municipal Bonds that are Secured by U.S. Treasury Obligations

Abstract

Fama (1977) and Miller (1977) predict that one minus the corporate tax rate will equate aftertax yields from comparable taxable and taxexempt bonds. Empirical evidence shows that long-term tax-exempt yields are higher than theory predicts. Two popular explanations for this empirical puzzle are that, relative to taxable bonds, municipal bonds bear more default risk and include costly call options. I study U.S. government secured municipal bond yields which are effectively default-free and noncallable. These municipal yields display the same tendency to be too high. I conclude that differential default risk and call options do not explain the municipal bond puzzle. This article is based on Chapter 1 of my dissertation at the University of Rochester. I thank my dissertation committee, John Long (chairman), Mike Barclay, and Neil Pearson, for their invaluable help and encouragement. I am very grateful to Tom Barone at J. J. Kenny and Co., Inc. for providing the municipal bond data used in this study. I thank Richard Green for providing me with the Salomon yield data.

Do personal taxes affect corporate financing decisions?

“…Two aspects of Green's analysis lend credibility to the approach I use to infer J : 1) Green notes that it p is better to use short-term yields to infer J because complicating factors, such as the deductibility of investment p interest expense at the personal level, are more pronounced for longer maturities, and 2) Green estimates implicit tax rates within subperiods corresponding to different tax regimes. Chalmers (1998) and others show that the implicit personal tax rate is lower if inferred from long-maturity munis and taxables, implying a smaller personal tax penalty than I estimate. See Mankiw and Poterba (1996) for a discussion about alternative approaches to inferring J ; I use the "traditional model" because it is the most widely used [e.g., Scholes and Wolfson (1992)].…”

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