Scott E. Hein and Jeffrey M. Mercer
Working Paper 2003-9a
Revised December 2003

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In 1997, the U.S. Treasury introduced Inflation Protection (or “Indexed Protected”) Securities, known as TIPS. with substantial promotional fanfare Yet, due in part to what some in the finance profession have described as a “tax disadvantage” placed upon TIPS, many are questioning whether they should appeal to a wide audience. Some, in fact, advise holding TIPS only in tax-deferred accounts. Several authors have since described these securities as “tax disadvantaged” relative to conventional securities, leading to substantial debate regarding their appropriateness outside of tax-deferred accounts. In this paper, the authors develop a framework that allows them to demonstrate that the tax treatment of TIPS is trivially different from that of conventional Treasury securities. Utilizing an after-tax valuation approach, they further show that under relatively conservative projections for inflation, TIPS generally have after-tax yields comparable to, if not exceeding, conventional fixed-rate Treasury securities. Moreover, the authors find evidence that since their introduction, TIPS have outperformed matched maturity conventional Treasury securities in terms of after-tax returns.

JEL classification: G0, G1, H2, H6

Keywords: Treasury securities, inflation protection, income taxes, interest rates

The authors wish to thank Naomi Boyd, Gerald Buetow, Peng Chen, Ken Cyree, Gerald Dwyer, Frank Fabozzi, Sattar Mansi, Eric McDonald, Bill Reichenstein, Clay Singleton, and Jonathan Stewart for comments on earlier versions of this paper. We also thank Dincer Kaya for research assistance. Scott E. Hein wishes to acknowledge the assistance of the Federal Reserve Bank of Atlanta in supporting this research. Comments are welcome. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Scott E. Hein, Briscoe Chair Professor of Finance, Rawls College of Business Administration, Texas Tech University, Lubbock, Texas 79409-2101, 806-742-3433, and Visiting Scholar, Federal Reserve Bank of Atlanta,, or Jeffrey M. Mercer, Associate Professor of Finance, Rawls College of Business Administration, Texas Tech University, Lubbock, Texas 79409-2101, 806-742-3365,