Journal of Financial Economics 17 (1986) 335-354.

North-Holland

EMPIRICAL DETERMINANTS OF THE RELATIVE YIELDS ON

TAXABLE AND TAX-EXEMPT SECURITIES*

Stephen A. BUSER
Ohio Srute tinwersrt_v. Columbus. OH 43210. lS.4

Patrick J. HESS

Received May 1984. final version received January 1986

Yields on short-term prime-grade municipals vary through time in relation to after-corporate-tax

yields on short-term U.S. Treasury securities. The pattern is not related to the default premium in
municipal yields or to the historical ceiling on bank deposit rates (Regulation Q). However. there
is a strong link to the default premium in corporate yields and to municipal holdings by large
commercial banks. These findings suggest that taxable and tax-exempt markets are linked both by
the capital-structure decisions of firms and by the tax-arbitrage activities of banks.

1. Introduction

The objective of this paper is to explain the variation through time in

relative yields on short-term taxable and tax-exempt government securities.
Two leading theoretical models, Millers (1977) corporate-capital-structure
equilibrium and Famas (1977) bank tax-arbitrage model, predict that the
personal tax rate of the marginal bondholder equals the corporate tax rate.
Using yields on newly-issued one-year prime-grade municipals and one-year
U.S. Treasuries, fig. 1 plots monthly estimates of the marginal bondholders
tax rate for the period January 1959 to December 1982.~~ For purposes of
comparison, the figure also plots the corporate tax rate. It is apparent from
this figure that changes in the corporate tax rate account for very little of the
variation in relative yields.

*The authors gratefully acknowledge the general comments of workshop participants at the
universities of Chicago, Harvard, Michigan, Minnesota, Ohio State, Pennsylvania and Southern
California. Special thanks are due to George Constantinides. Eugene Fama, Gailen Hite. E. Han
Kim, Merton Miller, Anthony Sanders, Rene Stulz. Paul Romer (the referee for the paper), and
the editor, G. William Schwert. Research assistance was provided by Chang Soo Hur.
The marginal bondholders tax rate is estimated as one minus the ratio of the prime-grade
municipal yield to the treasury yield. At this rate, after-tax treasury yields equal tax-exempt yields.
Yields are taken from Salomon Brothers (1983).

0304-405X/86/$3.50 0 1986, Elsevier Science Publishers B.V. (North-Holland)

 56

48

32

24L""""""""""""
1960 1965 1970 1975 1980

DATE

Fis 1. The corporate tax rate (step function) versus monthly estimates of the implied tax rate for
the marginal holder of one-year taable and tax-exempt government srcuritirs over the period
Januarv 1959 to December 1982.

Two explanations have been offered for the observed differences between
the corporate tax rate and our estimates of the marginal bondholders tax rate.
Trczinka (1982) argues that violations reflect a time-varying default premium
in prime-grade municipal yields. Skelton (1983) concludes that tax-exempt
yields were relatively high during periods when the taxable rate of interest
exceeded the rates that banks were allowed to pay on their deposits under the
historical restriction of Regulation Q. Either of these arguments can explain
why our estimate of the marginal bondholders tax rate varies more than the
corporate tax rate and why it is typically less than the corporate tax rate; but,
neither argument can explain why our estimate exceeds the corporate tax rate
for many months between 1976 and 1981.
Despite this empirical shortcoming, we examine the marginal explanatory
power of Trczinkas and Skeltons arguments. In regression equations that are
used to explain the ratio of tax-exempt and taxable yields, we find that the
estimated effect of municipal default risk is statistically insignificant. The
empirical results for Skeltons arguments are more interesting. We find that the
historical ceiling on bank deposit rates (Regulation Q) is statistically unim-
portant in explaining variation in the ratio of tax-exempt and taxable yields.
Nevertheless, there is statistically reliable evidence that changes in municipal
holdings of large commercial banks affect the ratio of tax-exempt and taxable
yields.
In addition to Trczinkas and Skeltons empirical modifications of Millers
and Famas hypotheses, we consider a third explanation for the observed
variation in relative yields. In generalized models of the corporate capital
structure decision. corporate contracting costs drive a wedge between the
returns to security holders and the marginal cost of issuing corporate securi-
ties.3As iMiller has observed, the marginal value of these dead-weight costs for
debt in excess of the dead-weight costs for equity causes the marginal
bondholders tax rate to differ from the corporate tax rate. and this difference
varies with the prospects of corporate bankruptcy.4 Our empirical estimates
are generally consistent with this observation: we lind that measures of
corporate default risk account for considerable variation in the ratio of
tax-exempt and taxable yields.
The body of our paper is organized as follows. Section 2 reviews the
competing hypotheses. Our data, empirical procedures and results are pre-
sented and discussed in section 3. The final section presents our conclusions.

2. Competing hypotheses

2. I. The corporate-tax-rate hypothesis

2. I. I. Millers equilibrium

Miller uses the corporate-capital-structure decision to derive the relation

between taxable and tax-exempt interest rates. He observes that abstracting
from potential dead-weight costs of issuin, 0 securities, the marginal cost of
equity is simply the risk-adjusted return on stock. 1Miller then argues that if
corporate equity escapes personal taxation. the risk-adjusted return on stock
equals the default-free tax-exempt rate of interest. Miller also notes that
interest payments to bondholders are deductible against corporate taxable
income. Accordingly, he argues that the marginal cost of debt equals the
risk-adjusted rate of interest times one minus the corporate tax rate. Combin-
ing these assumptions, Miller concludes that firms are indifferent between debt
and equity if and only if default-free tax-exempt and taxable yields are related
as

rO= (1 - TC)rT,

3 For example, see Myers (1976). Jensen and Meckling (1976), and Kim (1978).
4See Miller (1977, p. 271).
By risk-adjusted return we mean the expected return on the asset less its required risk
premium. The generic form is the assets expected return plus its covariance with marginal utility
scaled by expected marginal utility. See Lucas (1978).
338 2-t. Burt-r and P.J. Hess, Yields on ru.ruhle und ra.r-e.rempr homls

where rO is the default-free tax-exempt yield, To is the corporate tax rate, and
rT is the default-free taxable yield. Millers equilibrium (1) implies that the
ratio of tax-exempt and taxable yields (or one minus the marginal bondholders
tax rate) equals one minus the corporate tax rate.

2.1.2. Famas tax-arbitrage model

Fama (1977) notes that commercial banks are allowed to deduct interest
expense on debt that is used to purchase tax-exempt securities. He argues that
the after-corporate-tax cost of debt to banks must equal the tax-exempt yield
to avoid tax-arbitrage. As in Millers equilibrium, Fama abstracts from corpo-
rate contracting costs and arrives at an equilibrium condition that is identical
to Millers; namely, that the ratio of tax-exempt and taxable yields equals one
minus the corporate tax rate.

2.3. Empirical modifications of the corporate-tax-rate hypothesis

2.3.1. Municipal default risk

Trczinka argues that the prime-grade municipal yield includes a default

premium that varies with the level of municipal default risk. This conjecture
implies that our estimate of the marginal bondholders tax rate (one minus the
ratio of tax-exempt and taxable yields) systematically underestimates the
marginal bondholders tax rate. Trczinkas explanation can account for varia-
tion in our estimate and for the fact that our estimate is typically lower than
the corporate tax rate. However, a non-negative municipal-default premium
can not explain periods when the estimate is greater than the corporate tax
rate.

2.3.2. The effects of Regulation Q and tax-exempt holdings by institutions

Skelton takes a different approach in explaining the time-series variation of

the relative yields on tax-exempt and taxable securities. He argues that Famas
tax-arbitrage hypothesis generally holds, but during the period of Regulation
Q it was difficult for banks to raise funds when the default-free taxable rate of
interest was greater than the ceiling on bank deposits rates. Skelton reasons
that if banks were forced to curtail their tax-arbitrage activities then low-tax
rate individuals would have been forced to absorb the municipal holdings
liquidated by banks causing a decrease in the marginal bondholders tax rate.
Skeltons argument ignores Millers prediction that corporations would sub-
stitute debt for equity to clear the excess supply of tax-exempt securities. In
the absence of this supply-side adjustment, Skelton, like Trczinka, is able to
account for variation in our estimate of the marginal bondholders tax rate and
 S.A. Buer und P.J. Hess. Yields on rumble und tux-e.~empr hods 339

for the fact that our estimate is typically less than the corporate tax rate: but
again, like Trczinka. Skelton can not account for those periods when our
estimate is greater than the corporate tax rate.

2.4. Generalized models of corporate capital structure

Extensions of Millers corporate-capital-structure model include additional

factors in calculations of the marginal costs of debt and equity. As Jensen and
Meckling (1976) emphasize, firms incur agency costs when they issue securities
to outside investors. In addition. the issuance of debt increases the risk of
bankruptcy or general financial distress, and these states of nature may result
in additional dead-weight costs for firms. The added dead-weight costs can be
explicit, as in the case of bankruptcy costs6 or implicit as in the case of
financial distress costs. In these generalized models of the corporate-capital-
structure decision, the firms marginal cost of equity is the risk-adjusted return
on equity plus the marginal agency costs of the firms equity. Similarly. the
firms before-tax marginal cost of debt is the risk-adjusted return on taxable
debt plus the marginal non-interest-related costs of the firms debt. In the
generalized corporate-capital-structure equilibrium the full marginal costs of
debt and equity are equated:

r, + d,(l - 7,) = (rT + d,)(l - T,), (2)

where rs is the risk-adjusted return on equity, d, is the firms marginal agency
costs of equity, and d, is the marginal non-interest costs of the firms debt.
To allow for personal taxes on equity, we relate the risk-adjusted return on
equity to the default-free tax-exempt rate as

f. = r,(l - T,), (3)

where Tois the marginal personal
and (3) and using d = d, - d,
corporate debt, we represent the
librium condition for default-free
as
tax rate on equity returns. By combining (2)
to denote the excess contracting costs of
generalized corporate-capital-structure equi-
yields on .tax-exempt and taxable securities

(4)

Kim (1982) derives an equilibrium condition analogous to (4) for the case in
which equity escapes taxation (TV = 0).

6For estimates of the explicit costs of bankruptcy, see Warner (1977) and White (1983)
For further discussion, see Myers (1976) or Kim (1978).
RFor an alternative discussion, see Barnea, Haugen and Senbet (1981).
 Expressing the relation in terms of the marginal bondholders tax rate. (3)
implies that

1- Tb = (1 + d/+)(1 - ?)(l - 7,). (5)

It is clear from (5) that generalized models of corporate capital structure allow
for considerable variation in the marginal bondholders tax rate. In particular.
the marginal bondholders tax rate exceeds the corporate tax rate for suffi-
ciently low values of 0, and it is less than the corporate tax rate for higher
values of d. Thus as Miller has observed, in the generalized corporate-capital-
structure equilibrium, variation in the excess contracting costs of corporate
debt emerges as a critical determinant of the variation in the ratio of tax
exempt and taxable yields.
Often in finance it is assumed that returns on debt and equity are taxed
equivalently at the personal level. 9 Under this assumption, T>equals T,, and (5)
implies that the interest cost of debt and the differential between the marginal
non-interest costs of debt and the marginal agency costs of equity are
approximately equal:

d= +~~/(l - T,)

= rT for 7C= 0.5. (6)

The marginal investors tax rate would be approximately equal to:

TV = 1 - r-,/d.

Although formal determination of r. is beyond the scope of this paper. eq. (6)
suggests that there could be considerable variation in the marginal investors
tax rate even in the special case of equal taxation.

3. Empirical tests

In this section we examine the empirical determinants of the ratio of the

one-year prime-grade municipal yield and the after-corporate-tax yield on
one-year treasuries. We refer to this variable as the ratio of tax-equivalent
yields. A formal definition is provided in panel A of table 1 along with the
definitions of five variables that we use to explain the ratio. In panel B we
identify the sources of data and dates each of the time series is available.
Short-term municipal yields are available as of January 1950 on a first-of-month

A notable example is the Capital Asset Pricing Model. but it is by no means the only model
that makes this assumption. For example, Miller and Scholes (1978.) coqecture that the U.S. tax
code approaches a consumption tax. This implies no taxation of the returns on financial securities
unless they are used to finance consumption, and even then there is no differential taxation.
 X.1. Buser and P.J. Hess. Yields on taxable and tax-txempr bonds 341

Table 1

Panel A: Regression variables

RA TIO is the yield on newly-issued one-year prime-grade municipal securities divided by

the after-corporate-tax yield on one-year U.S. Treasury securities.
MUNISP is the yield spread for good-grade and prime-grade newly-issued one-year muni-
cipal securities divided by the after-corporate-tax yield on one-year U.S. Treasury
securities.
REGQ is one for months in which Regulation Q was binding and 0 othenvise.
MUNIHOLD is municipal holdings by large commercial banks (in millions of dollars).
RINDUS is the rate of change in aggregate industrial production.
.CORPSP is the yield spread for Baa corporate bonds and one-year U.S. Treasury securities
divided by the yield on one-year U.S. Treasury secunttes.

Panel B: Data
Series Dates available Source

Yield on newly-issued one-year l/59 to 12/82 Salomon Brothers. An Ana!vrrcal

prime-grade municipals Record of Yields and Yield Spreads
Yield on newly-issued one-year l/59 to 12/82 Salomon Brothers. An rlna~rfical
good-grade municipals Record of Yields and Yield Spreads
Yield on one-year Treasury l/59 to 12/82 Salomon Brothers, ;In Ana(vrical
securities Record of Yields und Yield Spreuds
Maximum federal corporate tax l/59 to 12/x2 U.S. Treasury Department,
rate (including surcharges) Staristics of Income: Corporare
Income Ta.r Rerurns
Municipal holdings by 6/66 to 12/83 Federul Reserve Bullerm
large commercial banks
Periods when Regulation l/59 to 12/52 Federal Reserve Bullerrn
Q was binding
Industrial production l/50 to 12/83 Fedeml Reserve Bulletin
Yield on Baa corporate bonds 6/59 to 12/82 Salomon Brothers, An i( na!vricul
Record of Yieldrsand Yield Spreads

basis; however, short-term taxable yields were reported on mid-month basis

over the early part of this period. First-of-month quotes are available for
short-term U.S. Treasury yields as of January 1959; bankers acceptances as of
January 1964; and certificates of deposits as of April 1965. To take full
advantage of the available data, we use one-year U.S. Treasury yields rather
than the series Skelton uses (bankers acceptances and certificates of deposits).
The municipal yield spread is examined in tests of Trczinkas hypothesis
that the ratio of tax-equivalent yields varies because of a municpal-default
premium. The Regulation Q variable and municipal holdings by large com-
mercial banks are used to test Skeltons version of the bank tax-arbitrage
hypothesis. The rate of change in industrial production and the corporate yield
342 S.A. Buser and P.J. Hers. Yields on raxuble und tux-exempt bon&

spread are included in tests of the hypothesis that the ratio of tax-equivalent
yields includes a measure of excess debt contracting costs that vary with the
prospects of corporate bankruptcy.

3.1. Tests for the separate effects of each variable

Lacking a specific structural model, our empirical tests are more ap-
propriately regarded as descriptive. We conduct two types of statistical tests
that fit under the general econometric rubric of causality tests: we cross-corre-
late estimates of the innovations (unexpected changes) in the ratio of tax-
equivalent yields and the other variables, and we estimate regression equations
for the ratio with contemporaneous and leading values of the other variables
serving as independent variables.
As a preliminary step, we need to estimate a model to extract innovations
from the observed series. To this end we estimate an ARIMA model for each
of the variables. Table 2 reports summary statistics, autocorrelations, and
partial autocorrelations for the ratio of tax-equivalent yields. The ARIMA
model estimate for the ratio is presented in table 3. The ARIMA model
estimate for each of the five explanatory variables is reported in the first panel
of the table summarizing the tests for the effects of the corresponding variable.
The ratio of tax-equivalent yields is a speculative price. To the extent that
our measure of innovations in the ratio captures unexpected changes, rational-
ity implies that the innovations will be orthogonal to any predetermined
variables. Under the maintained hypothesis of rationality, non-zero lagged
cross-correlations simply imply that lagged values of these variables may be
helpful in predicting future values of the ratio. Similar reasoning applies to
lead cross-correlations between the ratio and the municipal yield spread and
between the ratio and the corporate yield spread: yield spreads are specula-
tive prices, and hence their true innovations are unrelated to predetermined
variables. Although some of the lagged variables will almost surely appear to
be statistically significant, this tells us more about how our statistical model
differs from the markets expectations than about the hypotheses of interest.
Based on this reasoning, we only report contemporaneous and lead cross-cor-
relations for rates of change in industrial production and municipal holdings
of commercial banks and only contemporaneous cross-correlations for corpo-
rate and municipal yield spreads. lo Pierce (1977, p. 15) suggests the following
statistic as a test for the general level of cross-correlation:

Estimated relations between the lagged values were generally statistically insignificant and
much weaker than the contemporaneous and leading values.
 X.4. Buser and P.J. Hess, Yleldr on rnxableand tax-elempr bonds 343

Table 2
Summary statistics, autocorrelations and partial autocorrelations of the ratio of tax-equivalent
yields: January 1959 to December 1982.

Lags Levelsb (sample mean = 1.115. standard deviation = 0.132)

Autocorrelations
1-12 0.85 0.81 0.80 0.74 0.72 0.69 0.69 0.69 0.68 0.63 0.62 0.61
13-24 0.57 0.56 0.55 0.54 0.52 0.51 0.49 0.48 0.48 0.47 0.48 0.46
25-36 0.45 0.43 0.41 0.37 0.37 0.35 0.35 0.36 0.33 0.34 0.32 0.31
Partial autocorrelations
1-12 0.85 0.33 0.23 -0.06 0.07 0.02 0.14 0.12 0.02 -0.18 0.05 0.03
13-25 -0.03 0.02 0.00 0.00 -0.01 0.05 -0.05 0.01 0.08 0.03 0.06 -0.03
25-36 -0.05 -0.05 -0.03 -0.08 0.03 -0.03 0.04 0.07 -0.05 0.01 -0.01 0.03

Lags First differencesC (sample mean = - 0.004, standard deviation = 0.072)

Autocorrelations
l-12 -0.38 -0.07 0.15 -0.14 0.03 -0.09 -0.02 0.08 0.10 -0.16 0.07 0.07
13-24 -0.12 0.04 -0.02 0.02 -0.01 0.04 -0.05 -0.02 0.04 -0.08 0.09 0.00
25-36 -0.01 0.01 0.03 -0.09 0.05 -0.04 -0.07 0.14 -0.10 0.04 0.03 -0.01
Partial autocorrelations
1-12 -0.38 -0.25 0.03 -0.10 -0.04 -0.16 -0.13 -0.03 0.16 -0.07 -0.04 0.02
13-24 -0.03 -0.02 -0.03 -0.01 -0.06 0.04 -0.03 -0.09 -0.05 -0.07 0.02 0.03
25-36 0.03 0.02 0.07 -0.03 0.02 -0.05 -0.08 0.04 -0.03 -0.00 -0.04 0.02

a The ratio of tax-equivalent yields is the yield on newly-issued one-year prime-grade municipal
securities divided by the after-corporate-tax yield on one-year U.S. Treasury securities.
b2SS monthly observations.
287 monthly observations.

Table 3
Autoregressive integrated moving average model for the ratio of tax-equivalent ields: June 1959
to December 1982 (asymptotic standard errors in parentheses). z

(1 - B)RAnQ, = - 0.0004 + (1 - 0.499 B + 0.144 B3 - 0.225 B4 - 0.097 B6)S,

(0.0012) (0.052) (0.059) (0.059) (0.052)
Standard error of the estimate = 0.063
Box-Pierce Q statistic (48 degrees of freedom) = 31.78 Significance level = 0.97
Autocorrelations of residuals
Lags 1-12 -0.00 -0.04 -0.02 0.02 -0.01 -0.05 0.03 0.13 0.08 -0.10 -0.01 0.07

RATIO is the yield on newly-issued one-year prime-grade municipal securities divided by the
after-corporate-tax yield on one-year U.S. Treasury securities. B is the backshift operator. Z is a
random error term.
b2S3 monthly observations.
where N is the number of observations used in estimating the ARIMA
models, m is the number of cross-correlations, and r, is the estimate of
cross-correlation i. Pierce notes that under the null hypothesis of no cross-cor-
relation each r, is asymptotically normally, independently and identically
distributed with variance N-i, which implies that the U statistic is asymptoti-
cally cm-squared. However, as Durbin (1970) has pointed out in a general
setting and Sims (1977) in our specific application, under the alternative
hypothesis of non-zero cross-correlation the Pierce test statistic is biased in
favor of the null hypothesis. I1 Given this limitation, we simply regard this test
statistic as a way of describing the general level of cross-correlations.
To formally test the effect of each variable, we estimate the regression of
changes in the tax-equivalent yield ratio on contemporaneous and leading
values of the variable. Our results are reported in panel B of the corresponding
tables. The estimates assume that the disturbances of the regression follow the
same moving average process that changes in the ratio follow. Given this
assumption, the regressions are non-linear in their parameters, and we use a
Gauss-Newton iterative procedure in estimating them.

3.1. I. The municipal yield spread

In our initial estimates, we test Trczinkas hypothesis that our proxy for the
default-free tax-exempt yield (the prime-grade municipal yield) includes a
default premium that produces a bias in our estimates of the marginal
bondholders tax rate. If Trczinkas conjecture is correct, we would expect to
find a positive relationship between the ratio of tax-equivalent yields and
measures of municipal default risk. In our tests, we use the spread between
good-grade and prime-grade municipal yields as a proxy for the general level
of municipal-default risk.12 As table 4 rep arts, this variable has little explana-
tory power. Estimates of the contemporaneous cross-correlation and the

The procedure for estimating cross-correlations is conditioned on the estimated ARIMA

model. Unless the variables are unrelated, part of the correlation will be reflected in the ARIMA
estimates. See Nelson (1979) for a related discussion.
Events surrounding the New York City financial crisis provide casual support for the premise
that the good/prime mum spread reflects changes in the general level of municipal-default risk.
As a fraction of the after-corporate-tax treasury yield, the muni spread jumped from 4.7% in April
of 1975 to 7.3% in Llay and to 9.9% in July amid reports of potential default and a moratorium on
the repayment of city notes. The percentage premium fell to 2.7% in August following the
formation of the Mumcipal Assistance Corporation (MAC). However, tentative financial support
for MAC issues began to erode under a series of court challenges. and the percentage premium
jumped to 6.3% in November and remained at that level or higher until the eve of the 1976
presidential election. Candidate Carter pledged federal support for financially troubled cities, and
in September of 1976 the percentage premium dropped from 9.4Oc to a pre-crisis level of roughly
3% or 4%. Exceut for a brief interruntion in December (8%). followina an unfavorable court
ruling. and another in February of 1977 (8.7%) during a precarious MAC refunding. the premium
remained relatively stable and the crisis appears to have reached a temporary end.
 S.A. Buer and P.J. Hess. I-irldr on raxubie and xux-exempt bonds 345

Table 4
The effect of the municipal yield spread on the ratio of tax-equivalent yields..b

Panel A
Autoregressive mtegrared moving average model; June 1959 to December 1982
(asymptotic standard errors m parentheses)
(1 - B).ML.YISP, = - o.ooo3 - (1 - 0.452 E - 0.221 BE,
(0.W) (0 056) (0.055)
Standard error of the estimate = 0.021
Box-Pierce Q statistic (48 degrees of freedom) = 38.34 Significance level = 0.84
Contemporaneous cross-correlations = 0.028 Asymptotic standard error = 0.059

Panel B
Regression equation; June 1959 to December 1982
(l-B)RATIO,-- O.OO+Xt 0.036(1-B),MLSISf,+(l- 0.5&l/3+ O.l44B- 0.225B- 0.097B6)5,
(0.001, (0.174) (0.053) (0.059) (0.059) (0.052)
Standard error of the estimate = 0 063
Box-Pierce Q statistic (48 degrees of freedom) = 37.74 Significance level = 0.97.

ML.WISP is the yield spread for good-grade and prime-grade newly-issued one-year municipal securities
divided by the after-corporate-tax yield on one-year U.S. Treasury securities. R1 TfO is the yield on newly
issued one-year prime-grade municipal securities divided by the after-corporate-tax yield on one-year U.S.
Treasury securities. B is the backshift operator. E is a random error term.
b283 monthly observations.

regression coefficient are statistically insignificant. Although not reported,

similar estimates resulted from measuring municipal-default risk with the
prime/medium-grade yield spread and the good/medium-grade yield spread.
In toto, these results suggest that municipal-default risk has little, if any,
impact on the ratio of tax-equivalent yields.

3.1.2. Regulation Q
For the period January 1954 to December 1978, Skelton reports evidence of
a statistically significant increase in the relative yield on tax-exempt and
taxable securities during periods when the taxable rate of interest was greater
than the Regulation Q ceiling on bank deposit rates. He establishes this result
by comparing one-year prime-grade municipal yields to yields on six-month
bankers acceptances and six-month certificates of deposits.13 He models the
ratio of tax-exempt and taxable yields as a second-order autoregressive process
with two dummy variables: one for periods when Reg. Q was effective; and
one for periods when the corporate tax rate was 48% rather than 52%.
As table 2 indicates, the ratio of tax-equivalent yields appear to be non-sta-
tionary in its levels: all autocorrelations out to lag 36 are more than twice their

13As we have noted, prior to January 1964 the quotation dates are mid-month for Skeltons
taxable yield series and first-of-month for the municipal yield series.
346 S.A. Buser and P.J. Hess. Ywlak on taxable and tacexempt bon&

Table j
The effect of Regulation Q on the ratio of tax-equivalent yields.a

Panel A
Sk&ons model (levels): May 1959 to December 197Sb
(1 - 0.524 B - 0.320 B)RATKI, = 0.168 -r 0.023 REGQ, + i,
(0.063) (0.062) (0.046) (0.010)
Standard error of the estimate = 0.067
Box-Pierce Q statistic (45 degrees of freedom) = 59 00 Significance level = 0.08
Autocorrelauoos of residuals
Lags 1-12 -0.07 -0.14 0.18 -0.02 0.01 -0.09 -0.02 0.19 0.09 -0.13 0.07 0.10

Panel B
First Differences: June 1959 to December 1978
(1 - B)luTIO, = - O.WO9T 0.017 (1 - B)RECQ, + (1 - 0.530 B + 0.163 B - 0.207 B - 0.100 B6)E,
(0.0014) (0.016) (0.057) (0.065) (0.065) (0.057)
Standard error of the estimate = 0.064
Box-Pierce Q statistic (45 degrees of freedom) = 32.10 Significance level = 0.93
Autocorrelation of residuals
Lags 1-12 -0.01 -0.04 -0.01 0.04 -0.01 -0.05 0.02 0.16 0.06 -0.12 -0.04 0.05

REGQ is one for months in which Regulation Q was bmding and zero otherwise. RA TfO is the yield on
newly-issued one-year prime-grade municipal securities divided by the after-corporate-tax yield on one-year
U.S. Treasury securities. B is the backshift operator. P IS a random error term.
b236 monthly observations.
235 moathlv observations.

asymptotic standard error of 0.058 under the null hypothesis of zero autocor-
relation. However, because our ratio differs form Skeltons, we first attempt to
confirm Skeltons findings and then consider how to best test his hypothesis.
The preliminary results are shown in panel A of table 5 and are qualitatively
the same as Skeltons. Our estimate of the Reg. Q effect is positive, and it is
significant at about the 0.01 level in a one-tailed test, which is appropriate
given that bank tax-arbitrage is the alternative hypothesis.
Although we have confirmed Skeltons finding with our ratio, the autocorre-
lations of residuals reported in panel A of table 5 are large. The Box-Pierce Q
statistic is significant at about the 0.10 level. 14*15These results together with
the previously reported autocorrelations of the level of the ratio, suggest the
kind of spurious regression results documented by Granger and Newbold
(1974) and Newbold and Davies (1975). To adjust for this possibility, we

I4 Box and Pierce (1970).

The econometrics package used for our empirical work, RATS, calculates the Box-Pierce Q
statistic by considering the minimum of half the number of observations or three times the square
root of the number of observations in calculating the statistic. See Doan and Litterman (1984,
pp. 1-18).
 S.A. Burer and P.J. Hess, Yieidr on taxable and tax-exempt bon& 347

Table 6
The effect of Regulation Q on large commercial banks holdings of municipals; October 1966 to
December 1983.hb

(1 - B)MLWfHOLD, = 164.04 - 104.81 REGQ, + (1 - 0.214 B + 0.142 B);,

(64.24) (152.51) (0.068) (0.077)
Standard error of the estimate = 926.83
Box-Pierce Q statistic (42 degrees of freedom) = 25.96 Significance level = 0.98
Autocorrelations of residuals
Lags l-12 0.06 -0.02 0.06 0.03 0.02 0.01 0.07 0.10 -0.10 -0.03 0.01 0.02

aMUNIHOLD is municipal holdings by large commercial banks (in millions of dollars).

RATIO is the yield on newly-issued one-year prime-grade municipal securities divided by the
after-corporate-tax yield on one-year U.S. Treasury securities. E is the backshift operator. E is a
random error term.
b207 monthly observations.

estimate the effect of Reg. Q using first differences of the ratio of tax-e&iv-
alent yields. In particular, we estimate a moving-average model with non-zero
terms at lags 1, 3, 4 and 6 and a differenced Reg. Q dummy variable. These
model estimates are shown in panel B of table 5. The estimates differ sharply
from those reported in panel A. Most importantly, there is no reliable evidence
that first differences of the ratio are influenced by Reg. Q, and the residuals of
this model show no pronounced autocorrelations.t6

3.1.3. Municipal holdings by large commercial banks

The results reported in panel B of table 5 suggest that Skeltons evidence
should not be regarded as convincing. Nevertheless, it is overstated to regard
these results as evidence against the bank tax-arbitrage hypothesis. Banks may
face periodic constraints on their tax-arbitrage activities, but these periods
need not coincide with periods when Reg. Q was binding. If Reg. Q did not
restrict banks tax-arbitrage, it should not have affected their holdings of
municipals. We test for the impact of Reg. Q by modeling changes in holdings
of municipals by large commercial banks as a moving-average process with
non-zero terms at lags 2 and 12 and include the Reg. Q dummy variable in its
levels. These estimates are shown in table 6 and suggest Reg. Q does not have
a statistically significant impact on municipal holdings of large commercial
banks. Although not reported, we also experimented with a differenced Reg. Q
dummy variable with similar results.

t6As a check on the sensitivity of the test to the precise timing of the Reg. Q restriction, we also
experimented with one-month and two-month leads and lags of the variable. None of the
individual coefficients was significant, nor were the sum of the lead coefficients, the sum of the lag
coefficients or the sum of all coefficients.
For example, see Hendershott and Koch (1980).
 The insignificance of Reg. Q on large banks holdings of municipals sup-
ports the conjecture that the regulation does not constrain tax-arbitrage by
banks. And. if Reg. Q does not distort tax-arbitrage activities of banks, then
the tax-arbitrage hypothesis does not predict that it would affect the ratio of
tax-exempt and taxable yields. Panel A of table 7 provides evidence that is
consistent with the tax-arbitrage hypothesis; bank holdings of municipals
appear to have a statistically reliable inverse impact on the ratio of tax-equiv-
alent yields. The contemporaneous and two leading cross-correlations have a
U statistic of 11.629. Under the null hypothesis of zero cross-correlation such
a value is significant at about the 0.01 level. The largest cross-correlation
occurs at lead 2 and has a r-value of - 3.083 which is significant at the 0.002
level in a one-tailed test. Panel B reports our findings for the regression of
changes in the tax-equivalent yield ratio on changes in the contemporaneous
and twelve leading values of municipal holdings by large commercial banks.
We measure the overall impact as the sum of the individual coefficients. As the
tax-arbitrage hypothesis predicts, this sum is negative and significant at the
0.01 level. On balance, the evidence of table 7 is consistent with the tax-arbi-
trage hypothesis.

3.1.4. Industrial production

Table 8 reports our estimates for rates of change in industrial production.
The cross-correlations reported in panel A are generally negative, and lead 1 is
significantly so at the 0.01 level. The U statistic for the contemporaneous and
the leading cross-correlation is 8.822 and this is significant at about the 0.01
level. Panel B of table 8 reports similar results for the regression of changes in
the tax-equivalent yield ratio on the contemporaneous rate of change in
industrial production and twelve leading values. Seven of the estimated
coefficients are negative, and the sum of the estimates is significantly negative
at the 0.05 level in a one-tailed test. The cross-correlations and regression
estimates are consistent with generalized models of corporate capital structure.

3.1.5. The corporate yield spread

Leading rates of change in industrial production convey information about
expected corporate bankruptcy, but they also reflect unanticipated events.
Hence the estimates reported in table 8 suffer from the errors-in-variables
problem. The default premium in corporate yields is a contemporaneous proxy
for expected bankruptcy avoiding the errors-in-variables problem. Because an
increase in the corporate yields spread signals an increase in the probability of
corporate bankruptcy, the generalized corporate capital structure model pre-
dicts a positive impact on the ratio of tax-equivalent yields. Our estimates are
 Table I
c
m The effect of municipal holdings by large commercial banks on the ratio of tax-equivalent yields.

m
Panel A

Auloregrenswe rnlegratedmoving-average model; October IYbb to Dcccmber lYX3

(asymptotic standard errors in parcnrhcsr~)
(I,
(1 - B,MUNff/O/.D, = 14692 + (I 0.216 H + U 130 H)i,
P
(5X 37) (WJbX) (0.077)

Standard error of the cstimatc = Y2S.M)

P
Box-Pierce Q stlislic (42 degreer of frrcdonl) = 27 43 Significance lcvcl = 0 Yb
:
~~0ss-codati0ns of contemporaneous innovations in lax-rquwalen~ yield> and leading innovation, in munr~pal holding, by large commercial Banks; October lYb6 to Duxnber IV82
&
0 I 2 3 4 5 6 7 II Y IO
- __ - - ~ ~ __ ___ ~ - __
- 0.023 - 0.098 - 0.222 - 0.043 -O.llY - 0.050 -0017 -0052 -0.130 - 0.071 001)
Abymplolic amdard error = 0 072

Slandard error of IIIC cblinutr = OIMb

IbePicrcr Q slillislic (IV dcgrres of frccdow) = 2X I I Slgnlrvanrc lcvcl = IJ Yu

_a_ B,_ B, 8, fie w ri, s, L% I% 6,

0.001I 0.500 0.157 - 1.566 0.345 - 0.047 0.250 0.315 b-070 - 0.592 - 0 275
(0.0015) (0.612) (0.707) (0.710) (0.710) (0 705) (0.716) (0.725) (0.712) (0.702) (0 670)

a, a, a, 4
0531 0 162 0.263 -0 lsb-
(0.064) (0 075) (0.074) (0 065)

Sum of cwllicienls on changes in municipal holdings by large commrrual banks = - I H7g

Standard error of the sum = 0 731

I-slalihlic r&alive 10 zero = - 2.57 One-tailed signilicancr lrvcl = 0 01

MUNIIIOLD is muncipal holdings by large commercial banks (in millions of dollars). HA T/O is the yield on newly-issued one-year prime-grade municipal wcuritrrs dwdrd by the
after-Corp~rale-lax yield on one-year U.S. Treasury securities. B in the back,hift operator. i is a random error term.
b207 monthly observations.
IYS monthly observations. :
a
lY3 monthly observations.
 Table X

The erect of rates of channe in industrial production on the ratio of tax-equivalent viclds.
--
Panel A

Autoregmsive integratedmoving-averagemodel; June lY50 lo December 19X3

(I t 0.398 B)H/NDUS, - 0.0020 t i,
(0.046) (O.ooo7) .

Standard error of the estimate = 0.013

Box-Pierce Q btalirtic (60 degrees of freedom) = 42.41 Sigmlicance level = 0 Y6

Cro~~orrelat~on of conwmporaneous innowionr in the rario of tax-equwalznc yields

and leadmg innoulions in the rate 01 change in induaial production; June 1YSY 10 December IYX2

0 1 2 3 4 5 6 7 8 Y
_ __
0.072 - 0.161 0.w ___
- 0.066 --- 0.025 -0097 - 0.04x 0.065 0 03s - 0.022

Asympwic standard error = 0 05Y

Panel 1%

Regreraion equalion; June 195Y to December lY82

(I-A)HA7W,=a,,t &t,,,RlNDJ.S,,, t(l -1),H-82H-B,~~-84H*)i,

I-0
Standard error of the es,,ma,e = 0 063

Box-Puce Q alarislic (degreea of freedom) = 37.06 Signilicance level = 0 X7

8
au &I 6, 41 4, 1) 4
6, ___ 6, ~ 2, 61 a* 6, 61,
-__ % -._ __.~ ~ __
0.002 0.x31 -1.471-- 0.799 - 0.6Y3 0.902 -0463 ~~ 0.8X6 0.831 - 0.212 0.2X4 0 2Y9 - 0.6Y6 -0.1x2 E
(0.002) (0.428) (0.627) (0.6311) (0.638) (0.662) (0.669) (0 674) (0.697) (0.710) (0.702) (0 701) (0 6YO) (0478) $

B 8, B
L . 8?._ _~~~.~ -4
0.522 - 0.179 0 259 0 074
(0.053) (0.061) (0.061) (0.054)

Sum ol cocliicienlr on ritw of change in induaial produc~wn = - 0 657

Standard error of the sum = 0.351

,-~IP1I~IIcrclallvs IO rero 3 - 1 x7 One-tailed ragmlicance lovel = 0.04

-
XINUUS ir lhc rille or changu in aggregalc indurlrinl produc\ion HAlf0 i> the yield on newly-issued one-year prime.grade municipal securilo divided by ~hc
after-corporate-tax yield on one-year U.S. Tr~.~ury securilies. B 1s the backrhifl opw~mr. ? is a random error rerm
403 monthly observaGons.
283 monthly abservafions.
 X.4. Bwer and Pf. Hess. Yteldr on taxable and tax-exempt bonds 351

Table 9
The effect of the corporate yield spread on the ratio of tax-equivalent yields..b

Panel A
Autoregressive integrated mowng average model: June 1959 to December 1982
(asymptotic standard errors m parentheses)
(I- B)CORPSP,= ooGa2 t (I- 0.206 B)i,
(0.m) (0.059)
Standard error of the estimate = 0.094
Box-Pierce Q stattstx (48 degrees of freedom) = 37.93 Significance level = 0.85
Contemporaneous cross-correlation = 0 358 Asymptotic standard error = 0.059

Panel B
Regession equation: June 1959 to December 1982
(asymptotic standard errors in parentheses)
(1 - B)Mno, - - O.ooO5 + 0.169 (1 - BKORPSP, + (1 - 0.438 B + 0.151 B - 0.149 B - 0.104 EL);,
(0.0017l (0.035) (0.054) (0.059) (0.060) (0.054)
Standard error of the estimate - 0.061
Box-Pierce Q statistic (48 degrees of freedom) = 28.89 Significance level - 0.99

CORPSP is the yield spread for Baa corporate bonds and one-year U.S. Treasury securities divided by the
yield on one-year U.S. Treasury securities. R4 TIO is the yield on newly-issued one-year prime-grade municipal
securities divided by the after-corporate-tax yield on one-year U.S. Treasury securities. B is the backshift
operator. i is a random error term.
b283 monthly observations.

presented in table 9. Of the results presented thus far, these findings are the
most striking. Both the contemporaneous cross-correlation and the regression
coefficient are positive and significant at well beyond the 0.01 level.t8

3.2. Distinguishing among the competing effects

Of the five explanatory variables suggested by the various hypotheses, we
have found that the changes in municipal holdings by large commercial banks,
rates of change in industrial production and changes in the corporate yield
spread all account for part of the variation in the ratio of tax-equivalent yields.
Of these three, the corporate yield spread appears to have the strongest effect.
We would expect rates of change in industrial production and changes in the
corporate yield spread to be highly related; both variables are measuring the
effect of corporate-default risk. And because the corporate yield spread is a
better measure of the markets expectations, we would expect it to dominate
rates of change in industrial production. Similarly, it is possible that changes

18As an alternative measure of the corporate yield spread, we used the difference between
Moodys Baa and Aaa yields as a fraction of the one-year treasury yield. Our conclusions were not
effected: the contemporaneous cross-correlation is 0.19 and is significant at the 0.0007 level, and
the regression coefficient is 0.304 and significant at the 0.01 level.
 Table 10

Panel A
Regression of changes in the ratio of tax-equivalent yields on changes in the corporate yield spread
and changes in municipal holdings by large commercial banks; December 1966 to December 1982~h
I2

(1 -B)RATIO,=y,+y,(l-E)COR/SP,+ cp,(l -E)MlJNf//Ol.D,+; 10 5+(1-0,B-8,B3-03B4-0.,B6)7,

t-0
Standard error of the estimate = 0.063
Box-Pierce Q statistic (39 degrees of freedom) = 23.67 Significance level = 0.9X
Estimated coefficients .
(asymptotic standard errors in parentheses)

?ll 9, li, /i, li, li, /II li, s, p^, s, li, A 81,
- -
-0.1700.749~
0.002 - 0.092 - 1.485 0.377 - 0.078 - 0.528 0.264 - 0.020 - 0.592 - 0.333 - 0.2X4 O.lhX
(0.004) (0.038) (0.584) (0.669) (0.671) (0.670) (0.662) (0.674) (0.683) (0.670) (0.662) (0.632) (0.626) (0.577)

8, 82 83 4

0.518 - 0.164 0.213 0.193

(0.064) (0.074) (0.074) (0.064)
Sum of estimated coefficients on changes in municipal holdings by large commercial banks = - 2.6W
Standard error of sum = 0.747
r-statistic relative to zero = - 3.60 One-tailed significance level = 0.00015
 Panel U
Regression of changes in the ratio of tax-equivalent yields on changes in the corporate yield spread
and rates of change in industrial production; June 1959 to December 19X2,

(1-B)RATIO,=y,+y,(l-B)CORPSP,+~a,RINDS,,,+(l-O,B-o,B-~,B4-e,B,~,
r-0
Standard error of the estimate = 0.060
Box-Pierce Q statistic (48 degrees of freedom) = 30.99 Significance level = 0.97
Estimated coefficients
(asymptotic standard errors in parentheses)
a I ^ I .
? R % a1 a2 a3 a4 a5 % *7 % % %J al 1 I?
- ~ ___ _I ~._ -
o.ooo60.1x3 -iii-- - 1.349 0.y88-0.542 0.640 - 0.379 - 0.625 0.551 - 0.156 0.360 0.055 - 0.532 -0.3X3
(0.002) (0.038) (0.417) (0.586) (0.594) (0.594) (0.610) (0.612) (0.620) (0.639) (0.657) (0.655) (0.655) (0.647) (0.466)

8, 82 $3 84
~___ _____
0.457 - 0.160 0.169 0.111
(0.055) (0.061) (0.063) (0.056)
Sum of estimated coefficients on rates of change in industrial production = -0.32X
Standard error of the sum = 0.41Y
r-statistic relative to zero = 0.783 One-tailed significance level = 0.43

RATIO is the yield on newly-issued one-year prime-grade municipal securities divided by the after-corporate-tax yield on one-year U.S. Trrasury
securities. CORPSP is the yield spread for Baa corporate bonds and one-year U.S. Treasury securities divided by the yield on one-year U.S. Treasury
securities. MUNIHOLD is municipal holdings by large commercial banks (in millions of dollars.) B is the backshift operator. 7 is a random error
term.
b193 monthly observations.
RINDUS is the rate of change in aggregate industrial production.
283 monthly observations.

_
in municipal holdings of large commercial banks are somehow linked to
corporate-default risk. Although we ha\-e no explicit model for such a relation.
we can indirectly test for such an effect by simultaneously including the
corporate yield spread and changes in municipal holdings of large commercial
banks in the regression equation. These results are shown in panels A and B of
table 10.
As expected, changes in the corporate yield spread absorb the impact of
rates of change in industrial production. However, changes in municipal
holdings of large commercial banks continue to have significant marginal
explanatory power. In fact, the sum of the estimated coefficients on changes in
municipal holdings increases by over 40%. These results are consistent with the
hypothesis that both the corporate-capital-structure decision and bank-tax
arbitrage are at work in pricing taxable and tax-exempt bonds. It would,
however, be incorrect to interpret our results as structural. For example, it is
possible that both the corporate yield spread and municipal holdings of
commercial banks are providing marginal information about the same phe-
nomenon.

4. Summary and conclusions

Our estimates suggest that measures of corporate-default risk explain a

significant fraction of the variation in the ratio of tax-equivalent y-ields, but
measures of municipal-default risk do not. This finding supports generalized
models of corporate capital structure over the simple form of Millers equi-
librium. Our tests of the bank tax-arbitrage hypothesis are ambiguous. Al-
though we overturn Skeltons conclusion that Reg. Q had a significant impact
on the ratio of tax-equivalent yields, we find that changes in the municpal
holdings of large commercial banks do explain part of the variation in the
ratio of tax-equivalent yields. Further, we find that changes in municipal
holdings themselves are unrelated to Reg. Q. Together these findings suggest
that Reg. Q did not restrict tax arbitrage by banks, but that bank tax arbitrage
does affect the ratio of tax-equivalent yields.
In an important respect our conclusions merit qualification. The most direct
way to distinguish among hypotheses is to state them in terms of structural
equations and estimate how the structural equations fit the data. The problem
is that there are no obvious ways to simply state the respective hy-potheses:
hence, the estimation of structural equations is likely to tell us more about the
way we chose to model the hypotheses than about their relative merits. This
observation not withstanding, the study has produced some significant find-
ings. To us, the most striking result is the strong influence of the corporate
default premium on the ratio of tax-equivalent government yields. If bank-
ruptcy costs are a not significant determinant of the corporate-capital-struc-
ture decision, we are at a loss to rationalize this empirical finding.
 S. -I. Buter and P.J. Hess. Ydds on ta.rahle und rcr.r-e.rempt homls 355

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