Implied tax rates and the valuation of discount bonds

Discount bonds afford the investor the opportunity for capital gains. If for tax reasons the market is segmented on the demand side, investors in lower and lower tax brackets must be attracted when interest rates rise and the supply of discount bonds increases. Changes in the differential tax on capital gains and interest income also should affect relative demand. Testing these hypotheses with U.S. Treasury bond data, the implied tax rate is found to vary over time in a manner consistent with market segmentation and tax law changes.