Question

7. a. If the U.S. government raises the income tax rates, would this have any impact on a state government's bonds? Please explain your answer.

b.If the expectations theory of the term structure is correct, would a reduction in the supply of thirty-year Treasury bonds affect their yields?

Answer 1

1) When the U.S. government increases the income tax rates, it would impact on a state government's bonds. From federal income taxes, the payments of interest on municipal bonds are exempted and thus the factor would have similar effect on the demand for municipal bonds as an increase in their expected return. The raise in the income tax rates would lead to a rise in demand for municipal bonds. Consequently cause the rates of interest on municipal bonds to decline thus resulting to a lower cost on the state of borrowing government's funds

2) The theory attempts to predict what interest rates in the short-term would be in the future based on current interest rates in long-term. As per the expectations theory, Treasury bonds with different maturities are considered as the perfect substitutes. When the short-term rates remain constant, then a decline in the supply of thirty- year bonds would not impact their yields