The impact of proposed federal tax reforms on U.S. financial markets

Business Economics, Jan, 1996 by Albert E. DePrince, Jr., William F. Ford

Second, empirical research involving rates on Treasury strips suggests that they do not incorporate taxes into their general level. Because yields on Treasury coupon securities are related to the yields on strips through arbitrage, it would follow that the general level of yields on Treasury securities do not incorporate tax rates. If taxes are not paid by major investors, then tax rates would not enter into the calculation of the general level of interest rates.

Third, when tax rates change, most of the adjustment seems to take place in the yield on tax-exempt securities. However, if the yield on such securities incorporates tax rates, the tax-exempt yields should be stable and the taxable yields should adjust.

In sum, it is an assertion that the general level of rates will fall as the tax on personal interest income is scaled back or eliminated. Economic logic argues strongly that the general level of rates ought to be affected. However, there is no guarantee that the effect on the general rate level will match the changes in the average tax rate on interest income. This is an important empirical question that demands thorough analysis. Failure of the general level of rates to fall significantly would negate much of the expected benefit of the radical change in tax laws on the weighted average cost of capital. Indeed, if there is only a modest effect on the general level of rates, tax reform might unwittingly increase the WACC and thereby inhibit capital formation and economic expansion.

SELECTED REFERENCES

Freidler, George, Municipal Bonds and Tax Reform, Smith Barney, Inc., 1995. Jeffrey, Nancy Ann, "Flat-Tax Cloud Unlikely to Rain on Munis," The Wall Street Journal, March 19, 1995, pp. C1 and C15. Joint Economic Committee, Description and Analysis of Proposals to Replace the Federal Income Tax, U.S. Government Printing Office, June 5, 1995. Westbury, James, "Some Round Figures on the Flat Tax," The Wall Street Journal, May 18, 1995, p. A17. Richman, Louis S., "The Flat Tax," Fortune, June 12, 1995, pp. 36-46.