How Taxes Affect Economic Behavior

By Henry J. Aaron; Joseph A. Pechman | Go to book overview

Appendix B: Estimation of αb through Comparison of Taxable and Tax-free Interest Rates

In this appendix, αb, the value in the market of a dollar of interest payments relative to a dollar of capital gains, is estimated by comparing the equilibrium yields of the securities of the same corporate issuer: one taxable and one tax-exempt. If the two securities are identical in all respects except taxability of interest returns, so that they have identical risk, the risk premiums on the two securities, as valued in the market, must also be identical.98. If αbrb represents the expected return on taxable bonds and αfrf represents the expected return on tax-free bonds with comparable risk (each as valued relative to the equivalent amount of capital gains), then αbrb must equal αfrf. However, it is reasonable to suppose that as is about 1, since αf represents the value in the market of tax-free interest relative to capital gains, and capital gains are at worst relatively lightly taxed. It therefore follows that αb is about rf/rb.

We proceed by comparing the equilibrium yields of two securities issued (or guaranteed) by the same corporation: one taxable and one taxexempt. The usual problem with such an exercise is the difficulty of finding taxable and tax-free issues with comparable risk. Fortunately, it is possible to find a sample of several corporate issuers who simultaneously sold tax-exempt and taxable bonds. In recent periods, corporations have often been able to finance part of the expenditure for a particular plant with tax-exempt industrial revenue bonds. These bonds are issued by the local municipality, but all debt-service requirements are the responsibility of the corporation. Since the bond interest is exempt from personal income taxes, these bonds yield less than equivalent taxable securities. Obviously, the firm would choose to do all of its borrowing with these types of securities, but at the time of our study the total amount of each issue was limited by the U.S. Treasury to $3,500,000. Thus firms will often finance a new plant with industrial revenue bonds up to the maximum limit and then finance the remainder with regular taxable securities. This provides an opportunity to see how corporate bonds are priced in the market when they differ only in the tax status of the interest paid.

During 1978 we could find five such joint issues, where the terms of

____________________
98.
Were it not for the IRS ruling forbidding deduction of interest payments from debt undertaken to purchase tax-exempt bonds (26 U.S.C. sec. 265[2]), investors could go long in one security and short in the other and earn a riskless profit with no net investment.

-184-

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