Three professors from Willamette University have published a study reaching a surprising conclusion — municipalities do not sell more bonds when federal tax rates go up.
The study seeks to disprove what it calls the “conventional wisdom” that the exemption on municipal bond interest from federal income taxes enables municipalities to borrow more.
The conventional wisdom runs like this, the study claims — higher taxes stimulate demand for munis. Investors are willing to accept lower returns, which is the same thing as saying municipalities pay lower interest rates on tax-exempt bonds. Municipalities sell more tax-exempt bonds to take advantage of cheaper financing costs.
The study claims the conventional wisdom is dead wrong.
The reason is that although higher taxes allow municipalities to borrow more cheaply, those same taxes impose costs on the money municipalities save.
About 10 years ago, professors G. Marc Choate, Michael L. Hand, and Fred Thompson of the Willamette University Atkinson Graduate School of Management in Salem, Ore., were unsatisfied with the presumption that the federal tax exemption induces state and local governments to sell more bonds, and decided to test it.
What they found was that the connection between tax rates and the supply-demand equilibrium for municipals is about as random as a drunkard’s stroll.
They posted the paper, “The Influence of Income Tax Rates on the Market for Tax-Exempt Debt,” online in August.
The reason for their claim follows in oversimplified form: an increase in the tax rate makes tax-exempt yields more attractive to bondholders, bolstering demand. Up until this point, the authors are well in line with traditional thinking.
However, higher tax rates simultaneously make tax-exempt borrowing less attractive to municipalities. The increase in demand is therefore offset by a decline in supply, they claim.
This claim is counterintuitive and controversial. Greater demand for municipal debt would be accompanied by lower yields, so why should municipalities not want to borrow more?
The study establishes a model that presumes municipalities that issue tax-exempt bonds are essentially conducting arbitrage on behalf of their citizens.
For example, if a town wanted to build a $10 million school, it could raise $10 million in taxes immediately. Or, it could sell $10 million of tax-exempt bonds, spreading the taxpayers’ burden out over many years.
In the second option, the taxpayers could take the $10 million they did not pay in taxes and invest it, earning a greater return than the municipality pays on its tax-exempt debt.
When looked at this way, the advantage of tax-exempt financing is the excess return taxpayers can earn over the tax-exempt rate the town is paying. Unless the taxpayers can gain an arbitrage profit, the town is just borrowing from itself.
From this perspective, the reason higher taxes dampen the appeal of tax-exempt financing becomes apparent — whatever money taxpayers are saving when the municipality issues tax-exempt paper with lower rates they are simultaneously losing through taxes imposed on their investments.
It’s a wash. The same tax hike that eases borrowing costs for the municipality imposes costs on the money taxpayers save.
That is the crux of their thesis. Higher taxes mean more demand for tax-exempt debt, but, the authors claim, they also mean municipalities have less to gain by selling it.
The reverse is true as well. If tax rates go down, municipalities have more to gain from tax-exempt borrowing. Taxpayers can earn a greater arbitrage profit by investing the money they save. At the same time, though, lower taxes squelch demand for tax-exempt paper.
Either way, any shift in municipal bond supply will be met with an opposite shift in demand. The equilibrium is undisturbed.
The tax rate is thus not pertinent to the volume of tax-exempt issuance.
The authors of the study looked to actual bond issuance and tax rates over time to test whether their model was sufficiently more than theoretical.
What they found squared with their prediction. They did not detect a shred of proof that higher taxes stimulate tax-exempt bond issuance, nor that lower tax rates staunch it.
The authors examined effective tax rates from the Internal Revenue Service and municipal bond issuance from the Federal Reserve from 1963 to 1997.
They found no link.
“In a comprehensive series of statistical tests, there was never once revealed any significant relationship between the quantity of tax-exempt debt issue and the effective tax rate,” they wrote. “Communities do not increase spending through issue of tax-exempt debt merely because an increase in tax rates has reduced tax-exempt interest rates relative to taxable interest rates.”
The empirical evidence validates their model and debunks the conventional point of view, the authors claim. The resulting conclusion is remarkable — anybody examining tax rates to predict growth in the municipal market is wasting his time.