Question

In 2013, Congress approved legislation favored by the Obama administration to increase the income tax rate on high-income taxpayers from 35% to 39%.

Using supply and demand analysis, show what happens in the market for Treasury bonds and the market for Municipal bonds to explain how the increase in income tax rates for wealthy people to lower the interest rates on municipal bonds relative to the interest rate on Treasury bonds.

Answer 1

Interest income from municipal bonds (also called Muni bonds) is exempt from income tax, but interest income from treasury bonds is not. Hence, when income tax rate rises, muni bonds become more attractive to investors and they increase the demand for muni bonds, demanding less treasury bonds. Demand curve for muni bonds shifts rightward, increasing its price and quantity. Demand curve for treasury bonds shifts leftward, decreasing its price and quantity.

In each graph, D & S are initial bond demand and supply curves intersecting at point A with initial price P0 and quantity Q0. (i) Muni bonds

Higher demand shifts D0 right to D1, intersecting S at point B with higher price P1 and higher quantity Q1.

(ii) Treasury bonds

Lower demand shifts D0 left to D1, intersecting S at point B with lower price P1 and lower quantity Q1.

Interest rate is negatively related to bond price. Hence in muni bond market, higher bond price will lower interest rate. In treasury bond market, lower bond price will raise interest rate.