The Relationship between Government Financial Condition and Expected Tax Rates Reflected in Municipal Bond Yields

Yields on long-term municipal bonds reflect both current and expected future tax rates. This paper derives expected changes in tax rates from yields on short- and long-term municipal bonds and examines the relationship between expected changes in tax rates and the financial condition of the federal government between 1965 and 1994. The main empirical result is that a positive relationship exists between the expected tax rate and federal debt. Inflation also positively affects the expected tax rate, suggesting that investors may expect tight fiscal policies when inflation is high. Qualitative results are similar across specifications, estimators, and sample periods