In response to my post on Tuesday about a proposed financial transaction tax that would tax the purchase and sell of securities, Adam Rosenzweig sent along a link to his paper on the subject.  Imperfect Financial Markets and the Hidden Costs of a Modern Income Tax argues that the existing regime of taxing investing profits subsidizes speculation and suggests a derivatives transaction tax instead.  So, more issues to think about in this hot topic.  Here is the abstract:

The news has been filled with stories of meltdowns in the financial world, with the government, independent agencies, and politicians all devoting significant time and energy to coping with the consequences. As investment banks, hedge funds, and mortgage lenders continue to suffer massive losses, the government and its agents are left to try to pick up the pieces. Among other options being discussed, the government has proposed buying up illiquid assets of such investors, in effect betting on the price of illiquid mortgage securities. But what if, in addition to these more transparent problems, additional hidden costs from the financial crisis were being borne by the government in some other way? Even worse, what if the government had implicitly underwritten some of them in the first place? Building on insights from recent finance literature, this article contends that the government could in fact bear such hidden costs, through the interaction of a unique and underappreciated aspect of publicly traded financial derivatives - the ability to "decouple" the economic return of a risky asset from direct ownership of the underlying asset itself - and an income tax on risky investments. Under relatively conservative assumptions, such an analytical approach can produce a surprising result: the imposition of a facially neutral income tax can actually serve to subsidize speculators in financial derivatives, both in the model and as extrapolated to the real world. More specifically, an income tax in a world with imperfect financial markets can result in incentives to speculators to impose excessive amounts of liquidity risk on the markets, and the economy as a whole, with the government ultimately bearing the cost. These conclusions demonstrate the urgent need for a more comprehensive approach to financial derivative markets than has traditionally been undertaken, expanding the analysis beyond particular transactions to incorporate markets, traders, speculators, and investors more broadly. This article does so by proposing the adoption of a derivatives trading tax, not as a supplement to or replacement for, but rather as an integral part of, the income tax regime. Such a tax would not only offset the costs of imperfect financial markets borne by the government through the income tax, but could also ameliorate the suboptimal excess risk in the financial markets in the first place. Addressing such problems in this manner falls distinctly to the legal community, precisely because crafting the institutions and mechanisms necessary to equitably and efficiently allocate the costs and benefits of society is itself an inherently legal undertaking. Doing so may prove challenging, but it is a challenge to which the legal academy must rise for a comprehensive solution to be achieved.

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