DO MUNICIPAL BOND YIELDS FORECAST TAX POLICY

During the recent flat tax debate, interest rates on long-term municip al bonds rose relative to the rate on U.S. Treasury bonds. This was wi dely attributed to expectations of a reduction in future tax rates. Wh ile an axiom of finance states that current asset prices reflect expec tations about future events, there is no consensus on how sensitive mu nicipal bond yields are to expectations about: future tax rates. This study assesses that question by examining the relationship between the implicit tax rate and actual future tax rates. Efficient markets theo ry predicts that the implicit lax rate-the tax rate that equates the a fter-tax yield on a Treasury bond to the yield on a tax-exempt bond-wi ll be an excellent predictor of future tax rates. The author finds tha t although the Efficient Markets prediction is not supported, implicit tax rates do contain some information about future tax rates. The inf ormation content in implicit tar rates is particularly high around the time of major tax debates that have resulted in significant changes i n tax rates. At other times, including the flat tax debate of 1995-96, implicit tax rates carry little information about future tax rates.