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The Influence of Income Tax Rates on the Market for Tax-Exempt Debt  

Author:  G. Marc Choate.; Michael L. Hand.; Fred Thompson.

Source: Volume 31, Number 01, Spring 2010 , pp.41-60(20)

Municipal Finance Journal

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Based on the indirect arbitrage opportunities afforded citizens by tax-exempt debt issue, this article presents a model establishing equilibrium in the market for tax-exempt debt. The model yields two predictions: (1) Increases in federal income tax rates increase the spread between taxable and tax-exempt interest rates; (2) these increases have no effect on the equilibrium quantity demanded and supplied of tax-exempt debt. The latter prediction contrasts with a conventional point of view that increases in tax rates increase demand and supply of tax-exempt debt. The model’s predictions are supported by empirical evidence.

Keywords: Capital structure; indirect arbitrage gains; aggregate demand and supply equilibrium;

Affiliations:  1: Atkinson Graduate School of Management, Willamette University; 2: Atkinson Graduate School of Management, Willamette University; 3: Atkinson Graduate School of Management, Willamette University.

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