ON THE TAX STRUCTURE OF INTEREST RATES.

This paper analyzes the effects of tax-exempt coupons and capital gains on bond yields. The tax system is taken as given and approximately like the federal tax existing in the U.S. as of November 1969. Of particular interest are answers to such questions as the following. Under what conditions, if any, does there exist a single marginal tax rate which equates the after-tax yield on taxable bonds with different coupon rates? Under what conditions will this same marginal tax rate also equate the after-tax yield of tax-exempt and taxable bonds? How, if it exists, is this marginal tax rate determined? The answers to these questions do not seem immediately obvious. The analysis begins by considering the portfolio selection problem of an individual investor. An algorithm is developed to pick the optimal portfolio from the securities available. The effects on the optimal portfolio of changes in the amount available to invest and the yields of the securities are examined. Next, the determination of a market equilibrium is discussed. From this, conditions are developed under which a single marginal tax rate will equate the after-tax return on various classes of securities. In conclusion, some empirical questions are examined on recent observations of treasuries and tax-exempt housing notes.