effect for small issues only (Kidwell, Koch, This study uses a sample of individual and Stock, 1984), another found no sig- municipal bonds to estimate the effect of nifcant effect for large issues (Kidwell, state exemption of municipal bond interest Koch, and Stock, 1987), while a recent income on the yield to maturity offered by study found a significant effect for issues public issuers to ... [Show full abstract] finance their debt. The of any size (Brucato, Forbes, and Leonard, estimated average effect of a one percent- 1991). Moreover, none of the studies find- age point reduction in the state income tax ing a link between state tax treatment and rate on in-state municipal bond interest is borrowing costs addresses the question of a 3.9 basis point reduction in the yield to whether the estimated interest savings are maturity. A state-by-state comparison of of sufficient magnitude to outweigh the interest savings to estimated revenue loss state revenue foregone by the exemption. on a hypothetical $1 million serial bond This study estimates the effect of the suggests that aggregate savings are state tax exemption of in-state municipal achieved by an exemption policy only if bond interest income on yields to matu- more than half of state debt is held by rity and on state revenue losses. The es- nonresidents. timates of the effects on yields are de- rived from a random sample of 1443 serial issues and their component bonds issued during the January, 1982 to June, 1990 HIRTY-THREE states and the Dis- period. Unlike most previous studies, Ttrict of Columbia levy an individual which do not use individual bonds, our in- income tax and exempt from taxation in- terest savings estimates are based on an terest income earned on bonds issued by analysis of the yield to maturity offered governmental units located within their on individual bonds within the serials. In borders, while taxing interest earned on contrast, most studies have analyzed other municipal securities. Such an ex- variations in an aggregate interest mea- emption results in a loss of state revenue. sure, net interest costs (NIC).' Our data The justification for this "tax expendi- also span the time period of the Tax Re- ture" is the belief that it results in lower form Act of 1986 (TRA86), which has sig- borrowing costs for in-state issuers. The nificantly affected the municipal bond reasoning is that state residents will ac- market. cept a lower yield on in-state securities We begin with a review of existing because of the state income tax exemp- studies of the effect of state income tax- tion than they will accept on taxable, out- ation on municipal borrowing costs. This of-state securities. The prevalence of state review is followed by a discussion of the exemptions for in-state municipal income theoretical foundation for the study and suggests that this reasoning is widely ac- cepted by state policymakers. the derivation of our estimating equation.