Economic freedom and the mispricing of single-state municipal bond closed-end funds

Abstract

The Economic Freedom of North America Index (EFI) is a measure of the state-level institutional characteristics that promote economic activity. We use this index as a proxy for the degree of local market segmentation and test the hypothesis that single-state, municipal bond closed-end fund mispricing can be partially explained by a state’s EFI value. Using panel data analysis we find that EFI is significant in explaining observed variability in fund mispricing.

Appendices

Appendix A: Economic freedom of the states index

The Economic Freedom of the States Index (EFI) is an aggregate measure of economic variables reflecting the overall prevalence of those institutional characteristics thought to preserve individual freedoms in the private marketplace and promote economic prosperity in society. The value of this index for each state ranges from 0 (least economic freedom) to 10 (most economic freedom). The index is comprised of nine different economic measures grouped into three main categories:

• 1. Size of Government

  • a. General Government Consumption Expenditures as a Percent of State GDP

  • b. Transfers and Subsidies as a Percent of State GDP

• 2. Takings and Discriminatory Actions

  • a. Total Government Revenue from Own Sources as a Percent of State GDP

  • b. Top Marginal Income Tax Rates and Relevant Income Threshold

  • c. Indirect Taxation as a Percent of State GDP

  • d. Sales Taxes as a Percent of State GDP

• 3. Labor Market Freedoms

  • a. Minimum Wage Legislation

  • b. Government Employment as a Percent of Total State Employment

  • c. Union Density

The formulae for calculating the values of each of the nine subcategory areas, as well as the mathematical aggregation methodology for computing the index, can be found in Karabegovic and McMahon (2006). More information can be found at: http://www.fraserinstitute.org/researchandpublications/publications/3153.aspx

Appendix B: Philadelphia FRB state coincidence index

The Federal Reserve Bank of Philadelphia produces a consistent set of State Coincident Indexes (SCI) on a monthly basis for each of the 50 states. The data and information are available from their website at: http://www.philadelphiafed.org/research-and-data/regional-economy/indexes/coincident/.

Crone and Clayton-Matthews (2005) use a dynamic single-factor model to create state-level indexes, which estimates the following set of equations:

$$ \Delta {x_t} = \alpha + \beta (L)\Delta {s_t} + {\mu_t} $$

(1)

$$ D(L){\mu_t} = {\varepsilon_t} $$

(2)

$$ \phi (L)\Delta {s_t} = \delta + {\eta_t} $$

(3)

where x _t is the logarithm of the observed variable in period t, s _t is the logarithm of the state variable to be estimated (i.e., the common factor), and L represents the lag operator. The state variable, s _t , in Eq. 3 represents the underlying state of the economy and follows an autoregressive process. Crone and Clayton-Matthews (2005) use nonfarm payroll employment, average hours worked in manufacturing, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average) to develop a consistent set of state-level indexes. Standardized logged differences of the indicators and state variable are used to estimate (1) and (3). The trend of the index is set to the trend of the respective state gross domestic product (GDP).