Association for Public Policy Analysis & Management

State and local governments borrow by issuing municipal bonds in the capital markets to fund different public projects such as schools, bridges, and roads. Most municipal securities are exempt from federal, state, and certain local income taxes. Eliminating or limiting tax exempt status of municipal bonds becomes a potential policy alternative in periods of budgetary distress. However, literature provides little and conflicting estimates of the tax benefits of the municipal securities to investors as well as governments. I comb through large databases of primary and secondary market data to match tax-exempt municipal securities to their taxable counterparts in a novel way and estimate the market-implied tax benefits of munis and the indifference point for the marginal investor. Primary market results are consistent with the muni puzzle - exempt yields are higher than theory would predict. Secondary market results, however, display the reversal of the muni puzzle - investors are willing to give up more return for tax exemption in the secondary market than the theory would predict. This, in turn, is a signal of market inefficiency and implies that government debt issuers may be paying too much and that the market would likely clear at lower interest costs to sub-national governments.