| This dissertation studies the two tax effects on the term structure of interest rates: the income-capital gains tax effect, due to the differential taxation of income and capital gains, and the estate tax effect, due to the presence of a subset of U.S. Treasury long term bonds with a special estate tax provision, known as "flower bonds".; The income-capital gains tax effect is measured by estimating the term structure with a direct method with explicit consideration of income and capital gains taxation using nonlinear least squares during the periods of January-June 1982 and January 1975-December 1976. In 1982 the income-capital gains tax effect was on average 30 basis points of downward bias for spot rates up to 30 years, in the 1975-76 period the effect was negligible due to the lack of bonds selling at deep discounts, the source of this tax effect.; With respect to the estate tax effect, it is shown that flower bonds have different pricing equations than normal U.S. Treasury long term bonds, and that a flower bond can be conceptualized as a normal bond plus a complex life insurance contract. Three flower bond pricing models are derived by assuming that the mortality rate of the marginal investor in flower bonds is constant, increases linearly with age, or increases exponentially with age. Using the 1975-76 period it is shown that the mortality rates implicit in flower bonds' prices increase over time due to a reduction in the supply of flower bonds. The three pricing models were tested in the 1982 period, where flower premiums ranged from less than {dollar}1 to almost {dollar}50. All three models performed extremely well in absolute terms. In relative terms, the exponential model performed best with the linear model a close second. |
