Do municipal bond yields forecast tax policy?

During the recent flat tax debate, interest rates on long-term municipal bonds rose relative to the rate on U.S. Treasury bonds. This was widely attributed to expectations of a reduction in future tax rates. While an axiom of finance states that current asset prices reflect expectations about future events, there is no consensus on how sensitive municipal bond yields are to expectations about future tax rates. This study assesses that question by examining the relationship between the implicit tax rate and actual future tax rates.> Efficient markets theory predicts that the implicit tax rate--the tax rate that equates the after-tax yield on a Treasury bond to the yield on a tax-exempt bond--will be an excellent predictor of future tax rates. The author finds that although the Efficient Markets prediction is not supported, implicit tax rates do contain some information about future tax rates. The information content in implicit tax rates is particularly high around the time of major tax debates that have resulted in significant changes in tax rates. At other times, including the flat tax debate of 1996-96, implicit tax rates carry little information about future tax rates.