The term structure of relative yield spreads between U.S.

The theoretical attempts to study relative yield spreads of taxable and tax-exempt bonds started from Miller (1977) and Fama (1977).

Although relative yield spreads have become consistently narrower since then (see Table 1), the downward-sloping pattern of the term structure appeared [TABULAR DATA FOR TABLE 1 OMITTED] unchanged in general.

Since then the research focus gradually shifted to the term structure of relative yield spreads. The relative yield spread of taxable and tax-exempt bonds for a particular term-to-maturity is defined as the ratio of the yield spread of the two types of bonds of that term-to-maturity to the yield of the corresponding taxable bond.

Researchers who have studied taxable versus tax-exempt bond yields have focused rather narrowly on one or another factor that may account for the observed pattern of relative yield spreads. None of these papers has considered the yield spread effect of investors who choose taxable and tax-exempt bonds in a multi-period context that includes uncertainty about future income and tax rates.

Within the model framework, this paper shows how uncertain future income and tax rates, and income and substitution effects are related to the term structure of relative yield spreads.

This section shows how the term structure of relative yield spreads and uncertainty introduced by the exogenously-given income process are related.

Now consider the future relative yield spreads. From Equations 9, 10, 11, and 12, it can be shown that

Equations 17 and 18 indicate that there are two major factors affecting the future relative yield spreads. The first factor is the expected value of the future tax rate.

[E.sub.t]([[Tau].sub.t+i]) = [[Tau].sub.t] for i = 1, 2, and Equations 14, 17, and 18 imply that the future relative yield spreads are higher than the current relative yield spread:

As term-to-maturity increases, relative yield spreads would approach the (indifference) tax rate from above.

As term-to-maturity increases, relative yield spreads would fall way from the (indifference) tax rate.