Tax-Induced Bias in Reported Treasury Yields

TREASURY YIELD CURVES have served as the principal source of data for numerous studies dealing with various aspects of interest theory. Particularly in the term structure of interest rates area, reported yields on treasury securities have been used to test a number of alternative hypotheses.' It is the contention of this paper that the provisions of the current tax laws pertaining to investments in government bonds may lead to substantial bias in reported yields if coupons rates are significantly below current yields.2 The objective of this paper is to provide an empirical estimate of the "underlying" current yield curve at two points in recent history: September 23, 1968; and March 26, 1969. The meaning of an "underlying current yield curve" is as follows: If the Treasury were to issue a new series of bonds of all maturities and all the bonds were to sell at par, what coupon rates would have to be offered on the various maturities? This paper is divided into two parts. First, the impact of taxes on reported yields is analyzed in a conceptual way. Second, an attempt is made to estimate the degree of bias in reported yields as of the two dates noted above. "Underlying current yield" curves, adjusted for the effect of taxes, are derived for these two dates and compared to unadjusted yields.