Tax Advantages and Imperfect Competition in Auctions for Municipal Bonds

We study the interaction between tax advantages for municipal bonds and the market structure of auctions for these bonds. We show this interaction can limit the ability of bidders to extract information rents and is a crucial determinant of state and local governments' borrowing costs. Reduced-form estimates show that increasing the tax advantage by 3 pp. lowers mean borrowing costs by 9-10%, consistent with a greater-than-unity passthrough elasticity. We estimate a structural auction model to measure markups, and to illustrate and quantify how the interaction between tax policy and bidder strategic behavior leads to large passthrough elasticities. We use the estimated model to evaluate the efficiency of Obama and Trump administration policies that limit the tax advantage for municipal bonds. We find that the resulting increase in municipal borrowing costs is 2.8 times as large as the tax savings induced by these policies