Equivalent taxable yield is the effective interest rate that must be offered on a taxable bond instrument in order to arrive at the same after-tax yield built into a tax-exempt bond instrument. This amount is always higher than the interest rate on a tax-exempt bond, because the investor must pay income taxes on the income from the taxable bond. This amount depends on the incremental tax bracket of the investor. Thus, a wealthy investor in a high tax bracket will have a different equivalent taxable yield than an investor whose incremental tax bracket is lower. This means that a wealthy investor is more likely to invest in tax-exempt bonds.
The calculation of equivalent taxable yield is as follows:
Tax Free Bond Yield / (1 – Marginal tax rate)