The Changing Role of Commercial Banks in the Municipal Securities Market
Hein, Scott E., Koch, Timothy W., MacDonald, S. Scott, Journal of Money, Credit & Banking
COMMERCIAL BANKS have historically played a dominant role in the municipal securities market by owning more municipals than any other investor group. Until recently, they could borrow, invest the proceeds in municipals, and fully deduct all interest expense. The role of banks in affecting the yield relationship between municipal and taxable securities has been emphasized by Fama's (1977) tax arbitrage model and the market segmentation models of Mussa and Kormendi (1975), and Kidwell and Koch (1983). In contrast, Miller's (1977) capital structure argument suggests that banks should play no unique role in determining relative yields but instead the ratio of municipal to taxable yields should vary inversely with changes in marginal corporate income tax rates. One could argue that the relevant marginal investor is the individual investor, with changes in marginal personal income tax rates the dominate factor affecting relative yields. Alternatively, Peek and Wilcox (1986) predict that both changes in commerical bank behavior and changes in personal tax rates play a role in the determination of relative yields.
The 1980s represent an interesting period to contrast these different theories as banks ultimately lost their ability to deduct interest expense related to most municipal holdings, and marginal corporate and personal tax rates were reduced. The purpose of this paper is twofold. First, the impact of tax law changes on relative municipal and taxable yields is specified under each of the theories. Second, we empirically examine the effect of recent tax law changes on relative municipal and taxable yields. Specifically, we test whether the ratio of new issue municipal-to-U.S. Treasury yields (i) varied inversely with changes in corporate tax rates; (ii) varied inversely with changes in personal tax rates; (iii) increased when banks lost the interest deductibility of municipal carrying costs; and (iv) whether relative bank purchases of municipals affected the rate ratio both before and after the Tax Reform Act of 1986 (TRA86).(1)
1. RECENT TAX CHANGES AFFECTING RELATIVE YIELDS
Two types of federal tax changes potentially affected relative municipal and taxable yields: (i) changes in marginal corporate and personal income tax rates and (ii) the disallowance of interest deductions associated with the purchase of municipal securities. Marginal federal income tax rates have generally declined since the mid-1960s. The highest marginal corporate income tax rate generally fell from 48 percent in 1966 to 35 percent in 1988. The highest marginal personal tax rate generally fell even more over the same period, from 70 percent in 1966 to 33 percent in 1988.
Prior to 1983, commercial banks could invest in municipals and deduct all interest expense. Effective in 1983, Congress limited banks' interest deductibility to 85 percent of interest expense associated with new municipal investments. The deductible portion was further lowered to 80 percent beginning in 1985. Finally, effective August 1986, the TRA86 differentiated between "qualified" municipals that meet a small issue and essential public purpose standard, and all other "nonqualified" municipals. For commercial banks, interest expense associated with qualifieds remained 80 percent deductible, while interest expense associated with nonqualifieds was completely nondeductible.(2)
The lost interest deduction on nonqualified municipals represents an implicit tax on bank municipal interest. When banks were allowed to deduct all carrying costs, the effective bank tax rate on municipal interest was zero. When Congress made bank interest expense partially deductible in 1983, the effective tax rate was increased. The impact on banks, however, was considered minimal because after-tax municipal yields still exceeded after-tax yields on comparable taxables for commercial banks. The TRA86, on the other hand, sharply increased the effective bank tax rate on nonqualified municipal interest, thereby lowering after-tax yields below those on otherwise comparable qualified municipals and all taxable securities. …