Heterogeneous Taxes and Limited Risk Sharing: Evidence from Municipal Bonds

We evaluate the impacts of tax policy on asset returns using the U.S. municipal bond market. In theory, tax-induced ownership segmentation limits risk-sharing, creating downward-sloping regions of the aggregate demand curve for the asset. In the data, cross-state variation in tax privilege policies predicts differences in in-state ownership of local municipal bonds; the policies create incentives for concentrated local ownership. High tax privilege states have muni-bond yields that are more sensitive to variations in supply and local idiosyncratic risk. The effects are stronger when local investors face correlated background risk and/or diminishing marginal nonpecuniary benefits from holding local assets.