Tax News: Identifying the Household Consumption Response to Tax Expectations Using Municipal Bond Prices,” Working Paper

(for the latest draft, click here) Although theoretical models often emphasize fiscal foresight, most empirical studies neglect the role of news, thereby underestimating the total effect of tax changes. Measuring the path of expected future tax rates from the yield spread between taxable and tax-exempt bonds, this paper finds that consumption of high-income households increases by close to 1 % in response to news of a 1 % increase in expected after-tax lifetime income, consistent with the basic rational-expectations life-cycle theory. Using novel high-frequency bond data, I develop a model of the term structure of municipal yield spreads as a function of future top income tax rates and a risk premium. Testing the model using the presidential elections of 1992 and 2000 as two natural experiments, this paper shows that financial markets forecast future tax rates remarkably well in both the short and long run. Combining these market-based tax expectations with consumption data from the Consumer Expen-diture Survey shows that households who have lower income, less education, or are more credit constrained respond less to news. However, the same households also respond one-for-one with large news shocks, consistent with rational inattention. Overall, the results in this paper suggest that ignoring anticipation effects biases estimates of the effect of fiscal policy downward