Original issue premium (OIP) bonds are the norm in the US tax-exempt market but very rare in the taxable market. A tax subsidy helps explain this disparity. Unlike bonds issued at par or discount, the price of OIP bonds can fall and yet remain above par, providing secondary market buyers with more tax-exempt coupon and less taxable market discount gain. The subsidy for OIP bonds explains additional, previously undocumented empirical facts. In a calibration exercise, the subsidy’s expected cost to the U.S. Treasury is estimated at $1.7 billion per year.

Introduction

Tax incentives affect investors’ portfolio and trading choices, asset prices, and ultimately issuers’ financing choices. If these incentives are not the expression of optimal policies, the resulting distortions can cause inadvertent fiscal transfers, waste of real resources, and a suboptimal allocation of capital. The US municipal bond market is a unique setting to observe tax distortions. It is the world’s only sizable market for tax-exempt assets, with a total capitalization of nearly $4 trillion. The exemption of interest income attracts almost exclusively taxable investors, magnifying the effect of any remaining taxes. This paper shows an important, tax-driven municipal market peculiarity: the prevalence of bonds issued with a price above par, known as original issue premium (OIP) bonds. In 2015, 94% of all noncallable tax-exempt bonds were issued at a premium. These premiums are large: the average ten-year bond was issued at a price of 119 per 100 face value. By contrast, premium bonds are rarely offered in the taxable market. In 2015, less than 1% of corporate bonds, 17% of taxable municipal bonds, and 1% of US Treasury bonds were issued at a premium, with almost all the remainder issued near par.2 In this paper, I propose a novel explanation for this striking difference: the US tax code subsidizes premium tax-exempt bonds. I estimate this subsidy’s expected cost to the US Treasury to be about $1.7 billion per year. If a tax-exempt bond is bought and held to maturity, all investor income is tax exempt, and the bond’s issue price is inconsequential. The subsidy materializes only when bonds are sold at a loss in the secondary market. Consider the case of a bond issued at par, i.e., with an issue price equal to face value. Suppose interest rates rise and an investor buys the bond at a discount to face value. When the bond matures and the issuer pays off the full face value, the buyer realizes a gain. This gain is labeled a market discount gain and is taxed as ordinary income, regardless of whether the bond itself is taxable or tax exempt.3 Unlike par bonds, OIP tax-exempt bonds are tax efficient simply because their price can fall and yet remain above par, avoiding the market discount label and the associated tax.4 Fig. 1(a) illustrates a concrete example. At time 0 two identical investors, Alice and Bob, buy equal amounts of two identical, risk-free tax-exempt bond issues. The bonds are issued at par, i.e., with a coupon rate equal to the yield and a price equal to face value (normalized to 100). Shortly after, at time ε, yields rise and the market prices of the bonds drop to 90.