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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 municipal 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 municipal 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.
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