THE MARKET FOR TAX-EXEMPT ISSUES: WHY ARE THE YIELDS SO HIGH?

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Abstract
In mid-1981, yields on high quality, long-term tax-exempt bonds issued by state and local governments increased substantially relative to yields on U.S. Government bonds. At the short end of the maturity spectrum, no sharp relative rise in tax-exempt yields occurred. Of the possible explanations for these phenomena, we find that neither liquidity considerations, nor the behavior of banks and property and casualty companies, nor the recession can explain the entire rise. A key additional factor appears to be the Economic Recovery Tax Act of 1981 (ERTA), implying that the reduced benefits of tax exemption to issuers will persist.

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