Question

Predict what would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments. Do you think that it will then make sense for municipal bonds to be exempt from income taxes?

Short answer

Municipal bonds will be exempt from income tax because eliminating income tax raises the taxable equivalent yield. It means that if you don't pay your state income tax, you won't have to pay your federal income tax.

Step-by-step solution

Introduction

A bond is a fixed amount of income investment that is given to an entity for a specific length of time. Cities, states, and other government organisations issue municipal bonds.

To determine

Affect on municipal bond risk premium.

Explanation

After the government guarantees municipal bonds, the risk of default will be minimised, making these bonds more appealing to the public. The demand for municipal bonds will rise as a result of this.

Because the abolition of income tax will boost the taxable equivalent yield, municipal bonds will be tax-free. It means that if you don't pay your state income tax, you won't have to pay your federal income tax.