James Hines, University of Michigan - Banks and Tax-Exempt Debt Arbitrage

Title: Banks and Tax-Exempt Debt Arbitrage

Abstract: U.S. state and local bond interest is tax-exempt, making these bonds attractive to investors – though a tax rule limits arbitrage opportunities by restricting interest expense deductions. Prior to 1986, U.S. banks were not subject to the interest deduction limitation, making banks preferred holders of tax-exempt debt. U.S. banks used tax-exempt debt to reduce their tax liabilities by 40% in the 1950s, 60% in the 1960s, and more than 80% in the 1970s and early 1980s. Despite their special exemption, and in part because of their widespread holdings, banks did not benefit from investing in tax-exempt bonds, as competition reduced yields to the point of investor indifference.

Presenter: James R. Hines, University of Michigan

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