6. Comparison of After-Tax Returns

The Caldwell family is in the 28% federal income tax bracket. They are discussing the relative merits of using some of the household savings to buy a bond for a city water plant project that will pay 5.5% tax-free interest versus the alternative of buying a bond offered by the local electric power company that will pay 8% interest that is taxable. Which investment will provide the higher after-tax return for the Caldwells?

Since there is an implicit tax of 31.25% involved with the municipal bond (5.5% is 68.75% of 8%) the municipal bond is not a good idea for the Caldwell family. They would be better off with a taxable bond paying a return of 8%, which when taxed at their 28% marginal tax rate would result in an after-tax rate of return of 5.76%.

7. Rainy Day Funds

7. Rainy Day Funds (Continued)

a) Consider the desired expenditure path E to the revenue path R

Point Relationship between r and e

a R = E

b R > E

c R = E

d R < #

7. Rainy Day Funds (Continued)

b) With the state a point f, the state’s revenue exceeds that required to fund the desired expenditure path and the newspaper accounts will focus on the surplus accumulating in the state rainy day fund. Some politicians will be calling for reductions in state tax rates since the revenues being generated at current rates (given the rate of growth in the tax base) are in excess of those needed to fund the desired level of state expenditures. As state revenues decline relative to the desired expenditure path, however, newspaper stories will change to cover the triggering of a payout the rainy day fund. Beyond that, as the depth of the problem reached at point h becomes apparent, the newspaper stories will begin to focus on how the rainy day fund appears to be inadequate to carry the state through the economic downturn that it is experiencing. Some politicians will call for higher tax rates or expanded tax base definitions in order to generate more revenue, while others will call for reduced state expenditures.

c) Newspaper accounts in this situation will highlight falling state revenues and rising state spending. Initially (from point f to point g) it is a matter of a declining state surplus, but eventually (from point g to point h) it becomes matter of a substantial state deficit. Since news stories typically are written with a short time horizon in mind, the severity and tone of the stories will become more and more dire and doomsday in orientation until the revenuepath turns up after point h.

3. Treasury Inflation Protected Securities

a) Inflation erodes the buying power of securities while they are being held by the owner. This is the definition of inflation risk. When inflation occurs, then nominal interest rates usually rise which causes bond prices to decrease in value. This causes an actual loss for the bond holders.

b) With TIPS, the US Treasury increases the face value of the bonds each month by the inflation rate based on the CPI. Because the coupon payment is the coupon rate multiplied by the face value, both the principal of the bond and the coupon payments are immune to the effects of inflation and this means that the yield to maturity on TIPS is a real rate.