Heterogeneous Taxes and Limited Risk Sharing: Evidence from Municipal Bonds

We evaluate the impacts of tax policy on asset returns using the U.S. municipal bond market. In theory, tax-induced ownership segmentation limits risk sharing, creating downward-sloping regions of the aggregate demand curve for the asset. In the data, cross-state variation in tax privilege policies predicts differences in in-state ownership of local municipal bonds; the policies create incentives for concentrated local ownership. High tax privilege states have muni bond yields that are more sensitive to variations in supply and local idiosyncratic risk. The effects are stronger when local investors face correlated background risk and/or diminishing marginal nonpecuniary benefits from holding local assets.

Automated summary

This study examines the impact of tax policy on asset returns in the U.S. municipal bond market, finding that high-tax privilege states have municipal bond yields that are more sensitive to supply variations and local idiosyncratic risks. Tax-induced ownership segmentation creates incentives for concentrated local ownership, particularly in states with high tax privileges.