This paper presents a model of debt finance at the sub-national level
from which municipal bond supply equations are derived. Federal tax
considerations are shown to be important determinants of the price entering
the bond supply equation.
Using data on 40 state governments over a seven year period in the
1980s, I show that federal tax rates have an important effect on the supply
of municipal bonds - independent of the demand side effect that is usually
considered in the literature. Furthermore, the effect persists after
controlling for capital expenditures, thereby suggesting that municipal bond
proceeds are fungible at the margin. This has implications for the
measurement of the tax expenditure associated with tax exempt debt.
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