Financial Innovation, Tax Arbitrage, and Retrospective Taxation: The Problem with Passive Government Lending

Abstract

Recent years has seen an explosion of financial innovation aimed at exploiting inconsistencies in the income tax. In its most extreme form, parties engage in tax arbitrage, the practice of buying and selling the same cash flows to generate an after-tax profit. The primary tool for many of these arbitrage strategies is the realization requirement, which subjects taxpayers to tax on their gains and losses only when they sell their assets. Recently, several prominent economists have offered proposals that would reform the income tax while maintaining the realization requirement. This paper shows that if taxpayers are prevented from defaulting on their obligations to the government, then the proposals would prevent arbitrage as their authors claim. This is because the proposals would uniquely decompose the return on any investment into a return to capital and a return to risk and because they would charge interest on deferred taxes. If, however, taxpayers can default on their tax obligations, then these methods would not prevent arbitrage. The reason why is that the interest rate charged by the government would be below market because it would not reflect the possibility of default.

JEL Classification: H21