The Capitalization of the State Tax Exemption Benefit in Municipal Bond Yields

Thirty-three states treat in-state municipal bond interest income differently from out-of-state municipal bond interest income. While they tax the interest income of out-of-state bonds, they exempt interest income of in-state bonds from state taxes. This differential treatment in taxes creates a demand for in-state bonds and provides a disincentive for holding out-of-state bonds. A priori, this preferential treatment of in-state bonds would lower the interest yields on in-state bonds. This paper examines the degree to which the personal state tax exemption benefit is reflected in bond prices or yields in the secondary market for municipal bonds. The evidence suggests that the tax exemption benefit is fully capitalized in the bond's yield.