Economics Letters 35 (1991) 327-332 North-Holland 327 Taxable and tax-exempt interest rates zyxwvutsrqponmlkjih The link with inflation Scott E. Hein and Jeffrey M. Mercer zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHG Texas Tech Unwersity, Lubbock, TX 79409, USA Received 17 July 1990 Accepted 12 October 1990 A single-equation model utilizing taxable/tax-exempt yield spreads is developed to test restrictions required by the Darby-Feldstein inflation/tax hypothesis. Evidence indicates these restrictions generally can be rejected for post-Accord data and that there is important information in both yields linking them to inflation. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPON 1. Introduction Much attention has been devoted to examining the response of nominal interest rates to changes in inflationary expectations. Fisher (1930) hypothesized that the nominal rate of interest is the sum of two components: (1) the expected real rate of return, which is assumed to be independent of inflationary expectations, and (2) the expected rate of inflation. Under this hypothesis, changes in inflationary expectations result in proportional changes in the nominal rate of interest. Darby (1975) and Feldstein (1976) suggest, however, that the Fisher hypothesis is misspecified because it does not account for tax effects. Presuming that investors are concerned with after-tax real rates of return, their theory has lead some to suggest that an increase (decrease) in inflation expectations generally will lead to a greater-than-proportional increase (decrease) in the nominal interest rate. Empirical tests of the relationship between expected inflation and nominal interest rate. Empirical tests of the relationship between expected inflation and nominal interest rates have led to mixed findings. In a seminal piece, Fama (1975) finds evidence supporting the Fisher hypothesis. Cargill (1977), Fama and Gibbons (1982), (1984) and Carlson (1979) also find essentially a one-to-one relationship between taxable yields and expected inflation. In contrast, Yun (1984) provides evidence which is consistent with the Darby-Feldstein tax-rate hypothesis looking at tax-exempt and taxable yields. In this paper a single-equation model is developed considering both taxable and tax-exempt yields. Restrictions required by the Darby-Feldstein tax-rate hypothesis are examined for the post-Accord period. Generally, the evidence shows that these restrictions are rejected. In this light, separate non-nested models linking inflation to either taxable or tax-exempt yields are considered within the non-nested test approach of Davidson and MacKinnon (1981). 2. Model and methodology Yun (1984) has proposed a novel way of testing the Darby-Feldstein tax-rate hypothesis by examining the relative responses of taxable and tax-exempt yield to changes in expected inflation. 016%1765/91/$03.50 0 1991 - Elsevier Science Publishers B.V. (North-Holland)