Was the Tax-Exempt Bond Market Inefficient or Were Future Expected Tax Rates Negative?

This paper shows that the sharp narrowing with maturity of the spread between taxable and tax exempt yields leaves room for tax arbitrage. At times, tax exempt forward rates have exceeded taxable forward rat es. At such times, only expectations of higher taxes on Treasury than on municipal bonds would eliminate profit opportunities. The authors develop the idea of forward tax rates and compute forward tax rates for 1955-84. They outline tax arbitrage mechanisms involving private forward sale of long municipal bonds or the use of the municipal bond futures contract and show the potential profits. Copyright 1988 by American Finance Association.