Question

true or false

A taxpayer should invest in tax exempt bonds instead of taxable bonds if the interest on the exempt
bonds is greater than the interest on the taxable bonds multiplied by 1 minus the taxpayer's marginal
tax rate

Answer 1

Taxable bonds are bonds, interest earned on which is chargeable to tax at taxpayer's marginal tax rate. On the other hand, tax exempt bonds are bonds, interst earned on which is not chargeable to tax.

Which type of bond is better for any taxpayer depends on the interest rates of both type of bonds, and the marginal tax rate of the taxpayer. To compare both type of bonds, one has to calculate net proceeds (after tax proceeds) in one's hand, from bonds.

In respect of tax exempt bonds, interest earned is not chargeable to tax, therefore, entire interest proceeds are taxpayer's net proceeds. However, in respect of taxable bonds, the net proceeds for taxpayer are interst earned - tax on the interest earned. Tax on the interest earned can be calculated by multiplying the interest earned by the marginal tax rate. The same may be written in formula as :-

Net proceeds from taxable bonds = Interest - (Interest *Marginal Tax Rate)

The said formula can be solved further by taking interest as common :- Net proceeds from taxable bonds = Interest (1-marginal tax rate).

Now, if net proceeds from tax exempt bonds (i.e. Interest on tax exempt bonds) is more than net proceeds from taxable bonds ( i.e. Interest *(1-marginal tax rate)), than the tax exempt bonds is better option to invest.  

Hence, the given statement is True.