DP10971 Heterogenous Taxes and Limited Risk Sharing: Evidence from Municipal Bonds

Author(s): Tania Babina, Chotibhak Jotikasthira, Christian T Lundblad, Tarun Ramadorai
Publication Date: December 2015
Date Revised: June 2017
Keyword(s): clientele effects, fire sales, government debt, municipal bonds, ownership segmentation, public finance, Taxes
JEL(s): F30, G12, G15, H63
Programme Areas: Public Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10971

Heterogeneity in the taxation of asset returns can create ownership clienteles. Using a simple model, we demonstrate that an important consequence of tax-induced ownership segmentation is to limit risk-sharing, creating regions of the aggregate demand curve for the asset that are "downward-sloping.'' As a result, the constraints of the ownership clientele impact the asset price response to variations in asset supply, and make the asset's price more sensitive to movements in idiosyncratic risk. We test these predictions on U.S. municipal bonds, where cross-state variation in state tax privilege results in different levels of in-state ownership. In states with high tax-induced ownership segmentation, we find greater susceptibility of municipal bond yields to supply variation and heightened sensitivity of muni yields to local political uncertainty.