Have U.S. Budget Deficits Raised the Real Interest Rate Yield on Tax-Free Municipal Bonds?

Using a half century of data, this empirical study adopts a simple loanable funds to investigate the impact of the budget deficits on the ex post real interest rate yield on high grade municipal bonds in the U.S. Autoregressive 2SLS estimates for the 1960-2012 study period find that the ex post real interest rate yield on high grade municipal bonds is an increasing function of the ex post real interest rate yield on Moody’s Baa-rated corporate bonds, the ex post real interest rate yield on three-year U.S. Treasury notes, the real value of the S&P 500 stock index, and the federal budget deficit (relative to the GDP level). Based on these results, it is observed that factors elevating the federal budget deficit appear to raise the real cost of borrowing to the cities (of all sizes), counties, and states across the U.S. Over the long run, failure to address the federal budget issue could have profound negative impacts on the finances of U.S. cities, counties, and states and their economic activities.