Tax Arbitrage Feedback Theory

Abstract

A new angle for understanding the global credit crisis of 2008-2009 is presented. Based on control theory principles and the axiom that investors seek the highest, expected after-tax return, I develop the Tax Arbitrage Feedback Theory. TAFT explains how the subtle effects of differential tax rates for various market participants produce incentives that strongly contribute to instability and boom/bust economic activity. Moreover, TAFT explains how observed bond credit spreads should be impacted by differential tax rates, in addition to the conventional bankruptcy and recovery factors. The purpose of debt securitization products, when viewed through a TAFT lens, is not only diversification and partitioning of risk, but also tax minimization. Credit default swaps are revealed to be a massive tax arbitrage that shifted government tax receipts to Wall Street bonus pools and necessitated the creation of massive quantities of low credit quality debt.

Keywords: credit crisis, credit default swaps, cds, cdo, debt securitization, arbitrage

JEL Classification: D40, D57, E32, E44, E62, H21