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How Prevalent is Tax Arbitrage? Evidence from the Market for Municipal Bonds

This paper examines tax arbitrage in the market for municipal bonds. It poses a puzzle for the literature, however, in that we find little evidence of municipal bond tax arbitrage by nonfinancial corporations. Even among those firms engaged in arbitrage, many firms do less than a safe-harbor amount allowed by the tax authorities. Such a pattern is consistent with the presence of both fixed and marginal costs of arbitrage. The existence of such costs may help explain the municipal bond puzzle and, more broadly, why asset prices often only partially reflect the effects of tax differences.