If Congress changes the tax law so as to increase marginal tax rates, what will happen to the price of municipal bonds?

What will be an ideal response?

An increase in the maximum marginal tax rate for individuals will increase the attractiveness of municipal securities. This was seen with the Tax Act of 1990, which raised the maximum marginal tax rate to 33%. Ceteris paribus, an increase in tax rates has a positive effect on the price of municipal securities, as demand will increase. An increase in price is needed to restore the desired returns.

On the other hand, a decrease in the maximum marginal tax rate for individuals will decrease the attractiveness of municipal securities. This was seen with the Tax Reform Act of 1986 where the maximum marginal tax rate for individuals was reduced from 50% to 28%. Ceteris paribus, a decrease in tax rates has a negative effect on the price of municipal bonds, as demand will decrease. The effect of a lower tax rate was once again seen in 1995 with Congressional proposals regarding the introduction of a flat tax when tax-exempt municipal bonds began trading at lower prices. The higher the marginal tax rate, the greater the value of the tax exemption features. As the marginal tax rate declines, the price of a tax-exempt municipal security also declines.