Nominal Interest Rates and Marginal Tax Rates

It has been argued that nominal interest rates rise by more than a one-for-one adjustment to increases in expected inflation when interest income is taxed. With the exception of one study, researchers have not been able to document this relationship statistically. Work by Ayanian (1983) supposedly supports a strong Darby effect in the US, but closer examination of his methodology reveals that his model was misspecified. The Darby effect is correctly tested for by relating yields on tax-free assets to yields on taxable instruments. Since only municipal bonds are tax free, an adjustment is made for risk differences. The data are quarterly observations over the period 1952-1983 and are taken from Salomon Brothers Analytical Record of Yields and Yield Spreads. The results strongly support the hypothesis, as nominal interest rates appear to have risen enough to accommodate an average marginal tax rate of between 32% and 37%. Retesting of Ayanian's model using these data shows that it significantly underestimated the Darby effect.