To Tax or Not to Tax: Lessons from the Build America Bond Program about Optimal Federal Tax Policy for Municipal Bonds

Shama Gamkhar and Beibei Zou

Municipal Finance Journal, 2014, vol. 35, issue 3, 1 - 25

Abstract: This paper seeks to explore what we can learn from the experience of the Build America Bond program about optimal federal tax policy for municipal bonds. It examines the effect of repealing the tax-exempt status of municipal bonds on their yields by comparing tax-exempt bonds issued by state and local governments with the limited-period BAB program. The authors use an empirical model testing the effect of the tax-exempt status on the municipal bond yield, controlling for other yield determinants. The data for estimating this model are collected from the Municipal Securities Rulemaking Board for Texas for the period August to December 2010. The results from estimating the model show that the net effect of removing tax exemption on municipal interest costs is positive before considering the BAB direct subsidy. This indicates that the cost of long-term borrowing for state and local governments is likely to be affected by removing tax exemption. The authors also find that the yield spread between taxable and tax-exempt bonds narrows with longer bond maturities and the credit rating of bonds. The size of the bond issue, risk-free interest rates, call options, and yield to first call increase the yield spread between tax-exempt and taxable bonds. Additionally, the results suggest that the BAB program’s uniform subsidy of 35% of municipal bond interest cost was much larger than the cost difference between taxable BAB and tax-exempt municipal bonds.

Date: 2014
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