The Pricing of Tax-Exempt Bonds and the Miller Hypothesis



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    • State University of New York, Buffalo. I would like to thank Merton Miller, Michael Brennan, and the participants in the Finance workshop at SUNY-Buffalo for their comments and suggestions. I am further indebted to E. Han Kim for forcing me to rework many loose ends in earlier drafts.


This paper reports a new test of two competing theories of the relation between tax-exempt and taxable interest rates. The Miller hypothesis predicts that the tax-exempt rate is 52 percent of the taxable rate, while the institutional demand hypothesis predicts a volatile relationship. The tests in this paper employ a random intercept model to control for the risk of average interest rates. The results favor the Miller hypothesis. Marginal tax rates are found to be close to Miller's predicted 48 percent. The relationship is not influenced by relative demand or supply and the marginal tax rate appears stable over time.