Tax incentives and flow-performance sensitivity: Evidence from national and state municipal bond funds

Abstract

This paper examines how tax incentives create fundamentally different flow-performance relations for national and state-specific municipal bond mutual funds. We find that national funds, which invest in bonds across states and regions, exhibit strong concavity - outflows are more sensitive to poor performance than inflows to good performance. In contrast, investors in state-specific funds show greater leniency toward poor performance, particularly in states offering higher tax incentives for holding in-state bonds. By exploiting changes in state tax policy, we show this leniency diminishes when state tax rates decline, reducing these additional tax advantages. Our findings indicate that tax benefits moderate performance-driven outflows, which has direct implications for how effectively mutual funds can serve as stable intermediaries in the municipal bond market.