Market Segmentation and the Cost of Capital in a Domestic Market: Evidence from Municipal Bonds

We study the implications of market segmentation in a domestic setting, the US municipal bond market. A (state-level) segmentation of this market emerges from asymmetric tax exemption. Municipal bond investors are exempt from state and local taxes on bonds issued by their own state, but not on bonds issued by other states. We demonstrate that market segmentation imposes significant costs on both issuers and investors in the form of higher yields and higher costs of financial intermediation. Our results provide insight into some well-documented artifacts of the municipal bond market, such as high yields and the popularity of insurance.