Taxes on Tax-Exempt Bonds

Abstract

Individuals must pay tax on the secondary market transactions of tax-exempt bonds. The profits involving changes in bond prices are taxed either as income or as a capital gain. We find that municipal bonds carrying market discount, which are subject to income tax, command higher yields than municipal bonds not subject to taxes arising from secondary market trades. However, the after-tax yields on municipal bonds with market discount are around 30 basis points higher than yields on comparable municipal securities not subject to market discount taxation. We estimate an implied tax rate of around 80% using trades of municipal bonds entering regions where income tax rates apply.

Keywords: municipal bonds, income and capital gains tax, de minimis boundary, public finance

JEL Classification: G12, G28, H20, H24