Imperfect Financial Markets and the Hidden Costs of a Modern Income Tax
60 Pages Posted: 2 Oct 2008 Last revised: 27 Jul 2009
Date Written: 2009
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. 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 imperfection in the operation of public financial derivatives markets—the pricing of counterparty credit risk—and an income tax on risky investments. Under relatively conservative assumptions, such an approach can produce a surprising result: the imposition of a facially neutral income tax can actually serve to subsidize certain speculators in financial derivatives, both in the model and as extrapolated to the real world. In other words, an income tax in a world with imperfect financial markets can actually provide incentives to speculators to undertake excessively risky behavior, with the government ultimately bearing the cost.
These conclusions demonstrate the urgent need for a more comprehensive approach to the taxation of 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. By redefining the terms of the debate in this manner, a more efficient overall taxation regime can be crafted, while maintaining the normative goals of an income tax.
Keywords: Taxation, Risk, Financial Markets
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