LIQUIDITY, TAXES, AND SHORT-TERM TREASURY YIELDS

This article investigates differences in yields on identical Treasury notes and bills and shows that they reflect differences in liquidity (immediacy) risk and taxes. It proposes an empirical measure for differences in the liquidity risk of notes and bills: the volatility of the underlying rate times the ratio of bills' turnover to notes' turnover. Because differential taxes affect sellers but not buyers of bills and notes, the results reject, free of informational problems, the hypothesis that the notes' demand curve is horizontal. Note-bill yield differences also decrease with inventories of notes-the less liquid asset.