Financial Markets and Institutions (2-downloads)

Effects of the Bush Tax Cut and Its

Possible Repeal on Bond Interest Rates

The Bush tax cut passed in 2001 scheduled a reduction of the top income tax bracket

from 39% to 35% over a 10-year period. What is the effect of this income tax decrease

on interest rates in the municipal bond market relative to those in the Treasury

bond market?

Our supply-and-demand analysis provides the answer. A decreased income tax

rate for wealthy people means that the after-tax expected return on tax-free munic-

ipal bonds relative to that on Treasury bonds is lower, because the interest on

Treasury bonds is now taxed at a lower rate. Because municipal bonds now become

less desirable, their demand decreases, shifting the demand curve to the left, which

lowers their price and raises their interest rate. Conversely, the lower income tax rate

makes Treasury bonds more desirable; this change shifts their demand curve to the

right, raises their price, and lowers their interest rates.

Our analysis thus shows that the Bush tax cut raised the interest rates on munic-

ipal bonds relative to the interest rate on Treasury bonds.

With the possible repeal of the Bush tax cuts for wealthy people that may occur

under President Obama, the analysis would be reversed. Higher tax rates would raise

the after-tax expected return on tax-free municipal bonds relative to Treasury bonds.

Demand for municipal bonds would increase, shifting the demand curve to the right,

which raises their price and lowers their interest rate. Conversely, the higher tax

rate would make Treasury bonds less desirable, shifting their demand curve to the

left, lowering their price, and raising their interest rate. Higher tax rates would

thus result in lower interest rates on municipal bonds relative to the interest rate on

Treasury bonds.

http://stockcharts.com/

charts/YieldCurve.html

Access this site to look at

the dynamic yield curve 

at any point in time 

since 1995.

G O   O N L I N E

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Chapter 5 How Do Risk and Term Structure Affect Interest Rates?

97

case, the long-term interest rates are above the short-term interest rates as in the

Following the Financial News box; when yield curves are flat, short- and long-term

interest rates are the same; and when yield curves are inverted, long-term interest

rates are below short-term interest rates. Yield curves can also have more compli-

cated shapes in which they first slope up and then down, or vice versa. Why do we

usually see upward slopes of the yield curve but sometimes other shapes?

Besides explaining why yield curves take on different shapes at different times,

a good theory of the term structure of interest rates must explain the following

three important empirical facts: