The Long-Run Linkage between Yields on Treasury and Municipal Bonds and the 1986 Tax Act
26 Pages Posted: 29 Oct 1997
Date Written: March 18, 1997
Abstract
The Tax Act of 1986 changed the tax treatment of tax-exempt municipal bonds for banks. Since banks were the dominant participant in the municipal bond market until 1986, some believe that this resulted in the breakdown of the long-run equilibrium relationship between municipal and U.S. treasury securities of equal maturity. We present evidence that there was a significant break in the relationship muncipal and Treasury bonds around the time of the Tax Act but that break is in the mean of the equilibrium relationship and does not change the "slope" parameter that links the two interest rates in the long-run. Once this break is accounted for using a dummy variable the relationship between municipal and Treasury yields remains intact.
JEL Classification: E4, G1
Suggested Citation: Suggested Citation