Although I teach, write and practiced predominantly in corporate and commercial law, I also have an LL.M. in Tax. Granted, my LL.M. coursework largely focused on business taxation, and therefore falls squarely within my interests. Nonetheless, given that tax and corporate/commercial law are treated as separate legal disciplines, I see tremendous opportunities for comparative and interdisciplinary analysis among tax, corporate and commercial law.

For instance, I find it intriguing that courts employ highly divergent decision-making approaches in these realms. In the tax realm, courts tend to focus on the actual economic arrangement of the parties, in an effort to identify economic substance rather than mere contractual form. Courts presiding over tax cases tend to utilize more expansive and contextual interpretive methodologies, and routinely scrutinize objective and subjective intent and other "facts and circumstances." These approaches stand in contrast to the dominant, textualist interpretive paradigm in corporate and commercial law, which relies almost exclusively upon strict interpretive norms (such as rules of contract interpretation) to construe written agreements.

To be sure, these divergent methodologies reflect the differing goals of tax, corporate and commercial law. While jurisprudence across all three disciplines emphasizes the need for certainty, uniformity and predictability in the law, tax law remains manifestly skeptical of the party autonomy that corporate and commercial law strive to protect. Courts presiding over tax cases are often called upon to examine possible crimes against the public fisc; in contrast, courts presiding over corporate and commercial law cases are generally called upon to manage disputes among sophisticated parties to voluntary, utility-maximizing arrangements.

Yet despite these distinctions, courts are increasingly importing tax doctrine into the corporate and commercial law context. A classic example is the "debt recharacterization doctrine." In the federal income tax realm, considerably high stakes turn on the proper classification as debt or equity of a person's interest in a corporation. Generally speaking, the characterization of the investment as a loan means that payments of interest will be includible in gross income. In contrast, to the extent the investment is deemed to be an equity capital contribution, then the principal amount of the investment must be capitalized into the investor's basis in the corporation's stock. The tax treatment of any repayment will be determined pursuant to rules governing corporate distributions, with any amounts deemed to be a dividend includible in gross income. In light of these differing tax consequences, courts have developed multi-factor, highly facts-intensive and contextual analyses to recharacterize a purported debt instrument into an equity investment, and to reassign tax consequences accordingly.

The debt recharacterization doctrine was subsequently imported into the bankruptcy realm. In that context, if a court determines that an investment is equity rather than debt, then the claim will be treated as an equity ownership interest in respect of which no distribution of corporate assets can be made unless creditor claims are satisfied. Even within the less formalistic realm of bankruptcy, the importation of the debt recharacterization doctrine is a major departure from dominant jurisprudential norms. As a general matter, bankruptcy courts look to state contract law when matters arise under private agreements and there is no statutory law on point. For this reason, although bankruptcy courts have wide latitude to exercise legal and equitable powers, most matters that arise in respect of contracts are construed in accordance with state contract law, including rules of contract interpretation.

Of course, the bankruptcy context, much like the tax realm, may provide inherent justifications for the application of more expansive judicial methodologies. In particular, courts applying the debt recharacterization doctrine in bankruptcy matters are frequently responding to the plight of third party creditors who may recover less due to the crafty maneuvers of shareholders.

More recent cases demonstrate a willingness to import tax doctrine into corporate and commercial law even where the justifications for doing so are less obvious. For instance, in Coughlan v NXP BV, C.A. No. 5110-VCG (Del. Ch. Nov. 4, 2011), the Delaware Court of Chancery applied tax law's "step transaction doctrine" to an action brought by a stockholder representative seeking to construe terms of a merger agreement. In tax law, the step transaction doctrine is applied where parties engage in multiple transfers to circumvent rules that would apply to a more direct transfer. In Coughlan, the merger agreement provided that, in the event of a change in control of NXP or of pertinent corporate assets, the person acquiring NXP or the assets would be required to accelerate certain contingent payments or assume the obligations. The stockholder representative argued that NXP's two-step transfer of assets to a joint venture amounted to a change in control. NXP argued that it engaged in two transfers that were each permitted under the merger agreement. The court applied the step transaction doctrine, finding that the two transfers should be analyzed as a single transaction that ultimately effectuated a change in control.

The court explained that the step transaction doctrine has been imported into the Delaware corporate and transactional context as well as the bankruptcy realm. It cited a 2007 case construing provisions in a partnership agreement, whereby the Court of Chancery defended application of the doctrine: "I see no reason as a matter of law or equity why the step transaction principle should not be applied here. Indeed, partnership agreements in Delaware are treated exactly as they are treated in tax law, as contracts between the parties." Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *10 (Del. Ch. Sept. 14, 2007).

To be sure, such a rationale denies fundamental differences in tax, corporate and commercial law. However, in terms of judicial decision-making methodologies, the increased application of tax doctrine to cases in the corporate and commercial law realm may signal a movement away from formalism, and a rising interest in identifying the actual economic arrangement of parties as opposed to merely construing contractual form. Indeed, the Court of Chancery articulates this point in Coughlan, issuing words of caution to parties who rely on the written word in their business planning and legal advocacy: "transactional formalities will not blind the court to what truly occurred." Coughlan, C.A. No. 5110-VCG at 23.

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The local paper here last week mentioned in a fairly small article that Amazon had terminated its relationship with Illinois vendors who previously had earned commissions by referring internet customers to Amazon.  (Some bloggers earn commissions from Amazon by referring purchasing customers through their websites; the Glom does not.)  Why the big "You're Fired"?  Well, last week the governor of Illinois, Pat Quinn, signed into law a new tax law that would require Amazon to pay local sales tax on that purchase.  Amazon apparently did not think that was a good deal.  The state of Illinois has promised to find these abandoned Illinois vendors new commission-earning relationships with other Amazon-like retailers, presumably ones that have physical locations and already collect tax like Sears, Wal-Mart and Best Buy.  Some Illinois ex-affiliates are opting instead to take up business in another state, rather than wait for that help to come.

But, apparently, Illinois is not the only state looking for revenue cash left on the table (or under the sofa cushions) by passing an "Amazon tax."  (NYT article today here.)  And, apparently, Amazon is not that happy at being the biggest undertaxed cash cow in sight.  Amazon takes the position that it is required only to collect tax on sales to states where it has a presence, not mere internet affiliates or even warehouses (as in Texas).  Though the states are arguing that Amazon should be treated just like any other retailer that has to collect sales tax on its products, Amazon argues that it should be treated just like any other retailer without a brick and mortar presence in that state.  Here is a recent SSRN paper by Edward Zelinsky on why Amazon taxes violate federal law, citing a Colorado controversy.

Given the financial straits of many states, I bet this isn't the last we hear of this topic.

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What do our blogger emeritus Victor Fleischer, Kim Kardashian and the Gosselins have in common?  They are tabloid attractions!  Vic is featured today on the front page of the New York Post.  It's not every day that a law professor and a working paper are featured in the Post, but of course it is Vic, whose creative and aggressive scholarship on carried interest was picked up by the mainstream media before.  Vic's new target is the tax treatment of founder's stock, whereby entrepreneur's human capital becomes invested in stock, not salary, and therefore gets attractive tax treatment relative to the income of wage slaves like the rest of us.  His paper, Taxing Founder's Stock, and his power point slides are available on his website.

I read every word that Vic writes and can't wait until his articles are cited in People magazine.

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Is Delaware a corporate tax haven?

Evidence from the BYU Accounting Symposium, where I am sitting right now. This is a big part of the story:

One of the most prevalent corporate state tax planning strategies involves subsidiaries organized in the state of Delaware. This method, using a subsidiary commonly referred to as a Passive Investment Company (PIC) or Delaware Trademark Holding Company, exploits the fact that Delaware does not tax income generated by intangible assets, such as a trademark, when held by the Delaware-based subsidiaries of a Delaware holding company. To reduce taxation in a state that has high tax rates, the high-tax rate parent company or high-tax subsidiary pays the low-tax Delaware subsidiary a fee for the use of the trademark or other intangible asset. The fee is deductible against income earned in the high-tax state company, and is not taxable in the state of Delaware. Thus, by engaging in a PIC strategy, the firm does not pay taxes to any state on the income shifted to the Delaware subsidiary and benefits from a deduction taken in a high-tax state for use of the intangible asset.

The idea that Delaware is a tax haven is not new, exactly, but this is a fascinating paper. Of course, the strategy described above would result in other states are losing tax revenue to Delaware. Thus, according to one of the commentators in this session, 22 states now have taken steps to counter this strategy. Could the door for PICs be closing? I don't know the answer to this, but the authors claim based on interviews of accountants that the strategy is alive and well.

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We often get asked, here at the Conglomerate, why we don't monetize the blog - throw up advertising, talk to prospective suitors about the revenue stream, do a deal, and then outsource the business of writing posts offshore, while we live of the profits of our stock in Proctor and Gamble, or AIG, or whoever buys us.

One reason, sadly, is tax avoidance.  I'm a bit late to this, but the city of Philadelphia, if you haven't seen it, is charging blog owners who take ads for a business license.  Is that constitutional?  We're going to let Concurring Opinions bring the test case.

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The WSJ has an article today noting that the Senate Budget Committee's proposed 2011 budget resets the Bush era 15% corporate dividend tax to, wait for it, up to 39.6%.  Not the promised 20% rate that Obama had proposed -- 39.6%.  So, the ordinary income rate, which could be as high as 39.6%.  The 15% rate for dividends and capital gains is retained for couples making less than $250,000 and singles making less than $200,000.  The additional taxation rate will applied in addition to what the health care bill calls for -- a 3.8% "surcharge on investment income."  Here is the 2011 Budget Resolution, and here is the Chairman's Mark for the 2011 Budget Resolution, with some specifics.  I'm assuming that because the Chairman's Mark retains the 15% taxation for the under $250k/200k category, the WSJ is gathering by implication that the rate will return to ordinary income levels, which may be as high as 39.6% for the highest earners.  (I'm hoping that our corporate tax readers will chime in and correct/refine/slap down as necessary.)

So, the WSJ points out that this could make corporations more likely to borrow and pay tax-deductible interest rather than sell equity and pay heavily-taxed dividends.  But there's a lot of other ways that a high dividend rate could skew corporate decision-making.  And, it might have a higher impact on closely-held corporations that need to pay dividends to provide a return on capital.  So much for the small business love.

And, it seems that capital gains will also increase, but only to 20%, bringing us back to where we used to be in the 1990s, when dividends and capital gains were taxed differently.  So, let the gaming begin.  Again.

And watch for huge dividend announcements at the end of the year.  And huge sell-offs of appreciated stocks.

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My post describing Obama's itemized deduction proposal has generated some great comments, many of which I agree with.

First, it appears that I may have come across as supporting the general approach of phaseouts and other tinkering that effectively increases the marginal rate. This is absolutely not true. I could not agree with DirtyJobsGuy,Troyus, Joel, mochalite et al. more: the lack of transparency of the tax code is a serious problem. For example, Section 68 is supposedly a reduction in the benefit of itemized deductions for those who earn above a certain amount, but it is in fact, for most whom it affects, just a marginal rate increase (because of the way that it reduces the benefit). And the AMT is not only a shock to many taxpayers who end up owing it, but also permits all kinds of political shenanigans, where politicians can claim to be reducing taxes but in fact aren't (because any "reductions" in the regular tax are almost completely offset by increases in the amount of AMT owed). I do not think this is the way to run a tax system, and I strongly support tax simplification. Ideally, the government would set a broad base, impose rates on that, and proceed from there.

Second, bjh1970 points out that "[t]he overarching problem with anything linked to a specific income level is that it varies widely from place to place. I realize that $250K seems like a lot of money to someone in, say, Wichita ( and, in fact, IS a lot of money in someplace like Wichita) but for example, in the metro DC area...$250K is firmly middle of the middle class." This is really interesting. Our whole progressive rate structure is, of course, tied to income levels, and it rarely adjusts for location. Michael Knoll and Thomas Griffith, Taxing Sunny Days, 116 Harv. L. Rev. 987 (2003), provides a in-depth analysis of this complicated issue.

Third, EL asks, "won't this proposal reduce charitable giving?" The short answer is: almost certainly yes, though the degree to which it would do so is debated. The Center on Budget and Policy Priorities, for example thinks the effect would be small; others are more concerned. (More generally, Jon Bakija and Bradley Heim, How Does Charitable Giving Respond to Incentives and Income? Dynamic Panel Estimates Accounting for Predictable Changes in Taxation, discusses the question of the price elasticity of charitable giving.)

Finally, Joe "ha[s] to question the analysis of anyone who thinks a Health Savings Account deduction is reported on Schedule A and not on line 25 of the 1040. If you get something this basic wrong, I wonder what else is incorrect." I thank him for this correction, and urge him and others to look for additional things in the post that are objectively wrong--I am pretty sure my general analysis of the proposal is correct (in part because I read the sources I link to at the bottom of the page), but I always appreciate substantive corrections.

[Updated to fix links in the paragraph regarding charitable giving and to make clearer that the Bakija and Heim article does not stand in contrast to the previous two links, but rather provides a more general discussion of the elasticity of charitable giving.]

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Allow me to expand a bit on Christine's recent post on the mortgage interest deduction, which mentions in passing President Obama's proposal regarding itemized deductions.  The proposal would indeed, as the Wall Street Journal article to which Christine linked puts it, "scale back" the mortgage deduction, as well as deductions for "real-estate taxes, charitable contributions and other items." But this is not a proposal about the mortgage deduction (as real estate folks tend to claim) or about charitable contributions (as nonprofits tend to claim). Nothing is being repealed. And the proposal is not actually that shocking, for at least four reasons.

First, the proposal affects all itemized deductions, not just the mortgage deduction or the charitable deduction. Second, the proposal would limit deductions only for very high earners. Third, the proposal would only reduce, not eliminate, the benefits of itemized deductions, even for high earners. Fourth, this proposal is not anomalous, but rather would, if enacted, be only one of a number of provisions that already reduce the benefits of itemized deductions. Let's take each of these points in turn, to understand why the proposal is much less startling than it might first seem. 

First, the proposal does not target any particular deduction, but rather itemized deductions in general. What do I mean by "itemized deductions"? Some deductions, such as certain trade or business deductions, are "above-the-line" deductions. Everyone can get the benefit of these deductions. But most deductions are "below-the-line" deductions, or itemized deductions. Not everybody gets the benefit of itemized deductions, because each taxpayer has to choose between taking the standard deduction, on the one hand, and taking itemized deductions, on the other. For example, the 2009 standard deduction for a married couple was $11,400. So a married couple would itemize deductions only if their itemized deductions were more than $11,400. If their itemized deductions were less than that amount, they would not itemize, and they would get zero tax benefit from, say, making a charitable contribution of $5000. Given the size of the standard deduction, it is unsurprising that most taxpayers--about two-thirds of total tax returns--do not itemize their deductions. (In 2007, for example, only 50,544,470 out of 142,978,806 returns included itemized deductions.) Thus, about two-thirds of taxpayers already do not get the benefit of the mortgage interest deduction, the charitable deduction, real estate tax deduction, state tax deduction, and so forth. 

Second, the proposal would limit the benefits of itemized deductions only for very high-earning taxpayers. The proposal says that it would affect only married couples with an adjusted gross income (that is, total, or "gross," income minus above-the-line deductions) of more than $250,000, or individual filers with an adjusted gross income of more than $200,000. But I doubt this limit will have much effect on who the proposal would reach, because, as I explain further below, it's automatically limited only to those who pay taxes at a marginal rate of more than 28%. The 2009 tax bracket for married couples after the 28% tax bracket starts at $208,850, but that's taxable income, not adjusted gross income. That is, the $208,850 is after you reduce the adjusted gross income by personal exemptions and below-the-line deductions. In 2007, only 4,283,124 returns with itemized deductions had more than $200,000 of adjusted gross income. (And even some of those returns wouldn't get picked up by this proposal, because some of those were married couples.) So this proposal would affect approximately 2% of tax returns (based on the 2007 numbers).

Third, the proposal would not eliminate the deductions, even for those 2% of taxpayers who could be affected by it. Rather, the proposal would have an effect only to the extent that the itemized deductions reduced marginal dollars that were taxed at more than 28%. Thus, under our current tax rate structure, the proposal would at most reduce the benefit from an itemized deduction from (under current tax rates) 35 cents on the dollar to 28 cents on the dollar, a 20% reduction. For example, under current law, a $100 itemized deduction reduces taxable income by $100. If your marginal tax rate is 35%, you save $35 (35% of $100). Under the proposal, you would save $28.

Fourth, the proposal would be only one of a number of ways that, for the minority of taxpayers who do itemize, the benefit of itemized deductions is already limited. First, many itemized deductions are permitted only to the extent that such deductions exceed 2% of adjusted gross income. Second, in most years (though not 2010), most itemized deductions are partially phased out if the taxpayer earns above a certain amount. And third, the alternative minimum tax recaptures the tax benefits of itemized deductions. So even if you are a taxpayer who itemizes deductions instead of taking the standard deduction, the tax benefit you get from the deduction is less than it might initially seem.

Let's do an example, just to see what we're talking about here. The proposal wouldn't kick in until 2011, and we don't know what the tax code will look like then, or what the relevant inflation-adjusted amounts will be, so I'll use the 2009 tax brackets; estimate other inflation-adjusted amounts, such as the amount of the personal exemption and various thresholds; and allow the taxpayers to take the full amount of the personal exemption.  Also, I am making some educated guesses about how this would all work out; obviously, once we have statutory language, things could look a little different. But the below example captures, I think, the general idea.

Say you have a married couple with $250,000 adjusted gross income. To get from adjusted gross income to taxable income, they first subtract personal exemptions of $7500. They also have itemized deductions of $50,000, including some charitable deductions, some state and local taxes, a deduction for health savings account, [see Joe, in comments below] and a bad debt deduction.  Because some of these itemized deductions are permitted only to the extent they exceed 2% of the taxpayers' AGI, or $5000, the amount of itemized deductions is reduced to $45,000. They will also have to reduce their itemized deductions further, probably by 3% of the amount by which their AGI exceeds around $170,000. So they are allowed in total about $42,600 of itemized deductions. This reduces their taxable income to $199,900.

The itemized deductions that reduced their taxable income from $208,850 to $199,900 saved them tax at a rate of 28%, so those $8950 of deductions are not affected by the proposal. The remaining $33,650, however, reduced taxable income that was taxed at a marginal rate of 33%. So it saved them $11,045 (33% of $33,650). Under the proposal, they would be allowed to save only $9422 (28% of 33,650). So this proposal would increase their taxes by $1623.

Is this a good proposal? That's beyond the scope of this post (though I'd love to hear folks' thoughts about it in the comments). But if we're going to debate it, we should understand what we are really talking about.

More information:
The Joint Committee on Taxation explains the proposal.
Neil Buchanan has an excellent analysis of the proposal.
Examine data about 2007 tax returns to your heart's content.

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I'm very glad to be blogging at the Conglomerate--not just because it's one of my must-read blogs, but because this is, or so I've heard, a blog about "Business, Law, Economics, [and] Society," in that order.  So being asked to blog here feels like an acknowledgement that yes, tax is business too.  Or, to be more precise, that at least some tax professors write and teach about an area of law that directly addresses and affects businesses.  

This isn't news to the Conglomerate folks, of course.  I'm just one of many tax professors who have cycled through here.  Vic Fleischer, one of early members of The Conglomerate, is a tax and deal lawyer and scholar extraordinaire.  And Gordon was kind enough to include me in the most recent Law and Entrepreneurship Retreat, which included professors who specialize in, among other things, corporate governance, bankruptcy, finance, and securities regulation.

But far too many business law academics seem to forget that tax scholars have lots to say about business law.  After all, business lawyers couldn't get their deals done without the tax lawyers.  And while the corporate lawyers are arguing about indemnifications that might or might not get triggered years in the future, a good tax lawyer is putting money in the client's pocket right now, by structuring the deal to minimize the government's share.

I'm not sure why tax tends to get left out when people think about business law, or plan business law centers or programs or conferences.  Is it because tax, unlike securities regulation or corporate governance, does not seem intrinsically related to business?  Because not all tax scholarship relates to business law?  I would be very curious to hear people's thoughts on this.

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The mortgage interest deduction is funny.  For many people, it's one of thebigger tax deductions.  But, the more prudent you are, the smaller your deduction becomes.  As you pay your loan down, your deduction becomes smaller.  If you take out a 15 year instead of a 30 year, your deduction will be smaller.  However, if you do questionably prudent things, your deduction is larger.  If you take out a home equity loan to go on vacation, your deduction becomes larger.  Mortgage interest is secured, which makes it low to begin with, and then it is subsidized by the deduction.  So, paying extra on your mortgage loan each month instead of putting that money into the (non-recession) market is not mathematically smart.  If you can borrow at 5% and invest at 10%, then shouldn't you do that?  Except that it leaves you vulnerable to losing your home, which is bad.

After the sub-prime mortgage crisis, many thought that the mortgage interest deduction had a part to play.  The deduction really incentivizes debt, not home ownership.  There is no equity deduction, just a debt deduction.  Maybe we should repeal the deduction or decrease it.  Right now, mortgage rates are low (5% on a 30-year this morning), so the effect of repeal would be lessened, right?

But no one seems to have an appetite for changing the deduction according to this WSJ story.  Though Treasury is proposing a decrease in the deduction, no one is biting.  Lobbyists for the real estate industry say it would hurt an already ailing industry.  Last week, the NYT noted that mortgage applications were down.

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Christine continues to stir the pot with her incisive questions on the new proposed tax on bank (and other financial firm) risk-taking. Let me add a little more spice.

As Christine notes, politically, this tax seems like a win/win/win/win solution. It targets firms seen as responsible for the financial crisis, it supposedly soaks firms giving out bonuses, it cuts down on bank risk-taking, and it raises revenue to pay for the bailout. How could four wins possibly equal a loss?

Because Satan is always in the details. Here are some more questions to ask:

1. Tangled up in Taxes: I found the part of the President’s speech calling on banks to call off their accountants and lawyers from gaming the tax amusing. Our tax colleagues are going to have a field day with that comment. So will accountants (I am anxious to read Larry Cunningham’s further takes on this.

Tax law in the U.S. seems congenitally programmed towards adversarialism and complexity. Perhaps this tax will be different.

2. Taxes versus traditional banking law tools: My gut feeling tells me that if we are interested in regulating risk, then we should work traditional banking tools, like capital requirements, loan-to-value ratios etc. I asked earlier, how this tax would fit with traditional banking tools, such as capital requirements. Would it supplant them?

Going back to point 1, capital requirements have several advantages over taxes. Although banks certainly have incentives to game capital requirements, the incentives are likely weaker than to game taxes since capital remains the bank’s own money.

In terms of administrative posture, here is a question for Christine and David: do you think that bank regulators have a better tool kit to regulate bank risk-taking because the regulatory process (rule-making and inspections) is less like litigation than tax?

The problem with traditional bank tools, as Christine pointed out, is that they are neither politically sexy nor do they raise revenue. In other words – we only get one of the four wins mentioned at the beginning of the post.

3. Scalpels and sledgehammers: It might be better to go after each of these four “wins” – revenue, risk-taking, executive compensation, punishment – with separate tools, so we can accomplish their objectives in a more economically and legally principled fashion. It’s better to use four scalpels then one sledgehammer.

4. Bonuses and Zombies: As an example of how this win/win/win/win tax may not do what it sets out to do, consider the President’s statement that banks can’t complain that this tax will hurt the recovery when they are paying out bonuses. Two problems with that. First, dollars to donuts, banks will pay out bonuses regardless. Second, the tax doesn’t target only banks that pay bonuses; it focuses on the size of bank liabilities.

What happens to banks that are not paying out bonuses, but have large liabilities? Not every firm is in Goldman’s enviable financial situation. I worry that we are going to further un-level the playing field among financial firms between the currently strong and the currently weak, and raise the risk of zombifying sicker firms.

These are questions: I’m not dismissing this tax out of hand, but this needs a lot more thought. And of course I realize objections to the tax will be used by parties with all sorts of nefarious interests. But my interests are what is good policy, not who will score.

A more inchoate concern: I worry that this distracts from other regulatory reform pieces. The Obama Administration has a lot of good reform ideas (of course kinks need to be worked out). The waves from this ocean liner entering the harbor may push some of those smaller, nimbler boats out to sea.

Here is a more bottom line concern: is this the wrong moment in the recovery to impose a tax not based on profits but on risk-taking?  We do have a history in the U.S. of recoveries from crises being short-circuited by political demands.  The President spoke about escaping the boom and bust cycle.  I've been interested in and writing about financial cycles -- so that's music to my ears.  But, if we are going to make taxes countercylical - you raise the tax in boom years and lower it in bust years.  Not an easy thing to time.  It's also not easy to create the political discipline to raise and lower taxes at the right moment.

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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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David Brooks writes today in the NYT about economist and co-director of the Center for Economic and Policy Research Dean Baker's proposal to create a "financial transactions tax."  This tax (the writer suggests .25%) would be assessed on any sale or transfer of stocks, bonds or other financial asset.  The columnist does not specify whether the seller or the buyer would pay the tax, but in a Coasian world it does not matter.  (Part of the article seems to suggest it would be both -- by hypothesizing that someone would "pay a quarter-percent fee to purchase the asset in the first place and then another quarter percent to sell it."  I'm not sure if this was intended or not.  If so, then there is a total of a .5% fee every time a security changes hands.)  This fee is projected to raise perhaps $100 billion a year.

Of course, a lot of different new taxes would raise a lot of money -- that's what taxes do -- but we should try to anticipate how a tax (or a deduction) would skew behavior, and try to determine whether that is how behavior should be skewed.  The unintended consequences of varying tax policies may in fact add to economic troubles or just create new ones.  Many have argued that the mortgage tax deduction may have been an accomplice in the housing bubble, so let's be a little careful before we start imposing taxes or subsidizing behavior with deductions.

My first reaction at reading the first part of the article was that if we want the capital markets to be efficient, taxes lead us away from efficiencies.  (Remember one of the (false) assumptions of the efficient capital market hypothesis is that there are no transaction costs.  When taxes are present, studies show that markets move away from efficiency, and this is why we see "January effects" for certain types of investments and "November effects" for others.  Adding a new tax to buying and selling securities seems like it has the tendency to move the market away from efficiency.  At this point in time, we want trading, right?  The tax would have to be fairly nominal if it is not going to skew behavior.  Is .25% nominal enough?  Maybe.

Except that Professor Baker and David Brooks want the tax to skew behavior -- speculative behavior.  You see, it's the really bad people known as speculators who are ruining our markets, who "bring a manic quality to the markets, who treat it like a casino."  Bad speculators trade multiple times a day, so the small fee would add up and possibly make them just calm down and trade slowly, like the rest of us prudent investors.  The "beauty" of the tax is that it is a "progressive" tax "that discourages nonproductive activity."  Hopefully some tax people will jump in here, but I think of progressive taxes as those that affect people more as income increases.  Do we know that day traders or speculators have more income than "buy-and-hold investors"?  We like to say that the "buy-and-hold" people come out on top, so then isn't the tax regressive -- taxing the silly speculators who don't understand investing, just like lotteries are regressive taxes on poor people who are bad at math?  I guess the speculators we really, really hate are the ones that make money.  Bad speculators.

So, the second question is whether speculation really has no utility or even negative utility to the market.  Studies are just appearing telling us what happened when short-selling was banned last Fall, so maybe we'll have the answers soon.  But regardless of whether you are a speculator, prudent investors need speculators for liquidity, and issuers need the presence of liquidity to be able to sell publicly-traded shares in the first place.  If we tax speculators away, then our financial models that assume the ability to sell a particular security at some price may have to be tweaked once the buyers are gone.

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Details over at TaxProf, where I am guest-blogging this week.

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The Yale Law Journal Pocket Part has published Part I of its Sovereign Wealth Fund Symposium, including a brief but valuable contribution by Mihir Desai and Dhammika Dharmapala.  Desai and Dharmapala's essay responds to my paper, A Theory of Taxing Sovereign Wealth, in which I argue that current law subsidizes investment by sovereign wealth funds, and that we should change existing law to eliminate this subsidy.

Desai and Dharmapala argue that the subsidy I identify is illusory.  Similar to the work of Bittker, Knoll, and others on the tax exemption for non-profits, Desai and Dharmapala argue that because sovereign wealth funds are tax-exempt on all of their investments, they must employ a higher (after-tax) hurdle rate in evaluating investments than do taxable investors.  As such, they argue that imposing a tax on dividends at the same rate as taxable investors would drive sovereign wealth funds out of the equity sector and to other countries where such investments would not be taxed.  Exempting sovereign wealth funds from tax, they conclude, does not give them a competitive advantage over private investors, but merely allows them to make the sound financial investments that they would otherwise make. 

I disagree with Desai and Dharmapala for three reasons.  The first is factual.  Sovereign wealth funds are not, as they assume, exempt from tax everywhere.  In Germany and much of Europe, they are taxed as private investors. 

Second, as Michael Knoll has suggested, the difference in tax rates between interest and dividends for foreign private investors (zero vs. 30%, or 15% if a treaty applies) and SWFs (zero for both) may lead SWFs to allocate more investment into equities than private investors do.  In other words, the relevant comparison is not limited to how SWFs are taxed abroad, but also how equity is taxed relative to debt. 

Third -- and this is not so much a disagreement as an observation -- Desai and Dharmapala are engaged in a somewhat different inquiry than I am.  They assume that SWFs are investing purely for financial reasons, while I assume that some SWFs have mixed financial and geopolitical motives. 

This debate raises an empirical question that is difficult to answer -- if the US were to impose a tax on dividends received by SWFs, where would they shift their investments, assuming they would shift at all?  Because their investments are typically structured as convertible debt/equity hybrids, and because SWFs are sensitive to geopolitical concerns, I suspect that the closest substitute would be a subordinated debt investment in the US, not an equity investment abroad.  If that's right, then the difference between tax rates on debt and equity for private and sovereign investors is more important than the difference in tax rates on equity investments here and abroad. 

References

Mihir Desai & Dhammika Dharmapala, Taxing the Bandit Kings (Yale Law Journal Pocket Part)

Michael Knoll, Taxation and the Competitiveness of Sovereign Wealth Funds (SSRN draft)

Victor Fleischer, A Theory of Taxing Sovereign Wealth (NYU L Rev, forthcoming)

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