1. Università Bocconi, A.A: 2005-2006 1 Mec – Comparative public economics 1 Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi

2. Università Bocconi, A.A: 2005-2006 2 Mec – Comparative public economics 2 Outline Implicit taxes Clienteles Arbitrage Restrictions and frictions References: M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch.5 and 6

3. Università Bocconi, A.A: 2005-2006 3 Mec – Comparative public economics 3 Outline Implicit taxes Clienteles Arbitrage Restrictions and frictions

4. Università Bocconi, A.A: 2005-2006 4 Mec – Comparative public economics 4 Implicit taxes When two assets give rise to identical pretax cash flows, but one asset is taxed more favorably than the other one, taxpayers will bid for the right to hold the tax-favored asset As a result, the price of the tax-favored asset will increase relative to the price of the tax-disfavored asset This implies that the pretax rate of return of the tax- favored asset will fall below of that of the tax dis- favored asset In the absence of tax-rule restrictions or market frictions, in equilibrium the of after-tax returns will be the same for the marginal investor

5. Università Bocconi, A.A: 2005-2006 5 Mec – Comparative public economics 5 Implicit taxes: example Tax-favored status  Full tax exemption: municipal bonds US  Partial exemption or lower tax rates: capital gains  Tax credits: investment tax credit, targeted job credit  Tax deduction permitted at a rate faster than the decline in economic value of the asset Tax disfavored treatment  Special tax assessment  Tax deduction permitted at a rate lower than the decline in economic value of the asset

6. Università Bocconi, A.A: 2005-2006 6 Mec – Comparative public economics 6 Computing the implicit tax rate General approach Chose the benchmark (fully taxable bond) Compute the before-tax return on benchmark (R b ) Compute the (risk-adjusted) before-tax return on an alternative (tax favored) asset (R a ) The implicit tax is (R b - R a ) The implicit tax rate is given by: R b (1-t Ia ) = R a

7. Università Bocconi, A.A: 2005-2006 7 Mec – Comparative public economics 7 Computing implicit taxes: example 2 years10 years20 years Municipal bonds US (AAA) 3.05%3.57%4.04% Treasury bonds US4.59%4.51%4.76% Implicit tax33.5%20.8%15.1%

8. Università Bocconi, A.A: 2005-2006 8 Mec – Comparative public economics 8 Computing implicit taxes: differentially taxed assests Equilibrium risk-adjusted after-tax return: R* Explicit tax: (R a -R*) Total tax = Implicit tax + Explicit tax = (R b –R a ) +(R a -R*) = (R b -R*) Total tax rate = (R b -R*)/R b The total tax rate is the same for all assets

9. Università Bocconi, A.A: 2005-2006 9 Mec – Comparative public economics 9 Equilibrio nel mercato dei capitali Fully taxable bond Partially taxabale bond Tax exempt bond Pre-tax returnR b = 10%R p =8%R e = 7% Implicit tax (1)R b – R b = 0%R b – R p = 2%R b – R e = 3% Implicit tax rate = (1)/ R b 0%20%30% Explicit tax (2)R b – R e = 3%R p – R e = 1%R e – R e = 0% Explicit tax rate = (2)/ R b 30%10%0% Total tax =1+23%

10. Università Bocconi, A.A: 2005-2006 10 Mec – Comparative public economics 10 Outline Implicit taxes Clienteles Arbitrage Restrictions and frictions

11. Università Bocconi, A.A: 2005-2006 11 Mec – Comparative public economics 11 Clienteles When all taxpayers are taxed in the same way in equilibrium taxpayers are indifferent between purchasing any of two differentially taxed assets When taxpayers are differentially taxed the equality of post-tax returns may hold just for one type Marginal investors: taxpayers who are indifferent between purchasing two equally risky assets which are taxed differently: for these investors the explicit tax rate is equal to their statutory marginal tax rate Inframarginal investors: taxpayers that face explicit tax rates different from their statutory marginal tax rate Inframarginal investors with high marginal tax rates are led to invest in assets that bear high implicit rates

12. Università Bocconi, A.A: 2005-2006 12 Mec – Comparative public economics 12 Clienteles: example Municipal bonds: Ra = 7% Fully taxable bonds: Rb = 10% Implicit tax rate = (.1-.7)/.1 = 30% Investor with marginal rate equal to 40% Net return on Municipal bonds:.07 -.4*.07 =.042 Net return on fully taxable bonds:.1 -.4*.1 =.06

13. Università Bocconi, A.A: 2005-2006 13 Mec – Comparative public economics 13 Outline Implicit taxes Clienteles Arbitrage Restrictions and frictions

14. Università Bocconi, A.A: 2005-2006 14 Mec – Comparative public economics 14 Tax arbitrage Strictly speaking: the purchase of one asset (a “long position”) and the sale of another (a “short position”) to create a sure profit despite a zero level of investment Loosely speaking: an investment plan with a risky return due to the fiscal system. Organizational form arbitrage: long position through a favorably taxed organizational form and a short position through a unfavorably taxed organizational form Clientele-based arbitrage: reducing explicit tax liabilities at the expense of increasing implicit tax liabilities, or vice versa Two conditions: 1) taxpayer can take both long and short positions in differentially taxed assets, at least one of which bears some implicit tax 2) taxpayers face different marginal tax rates

15. Università Bocconi, A.A: 2005-2006 15 Mec – Comparative public economics 15 Organizational-form arbitrage: example Invest for 2 years in a fully taxable bond (no implicit taxes) with pre-tax rate R through a savings vehicle II (SPDA) Borrow (via issuing bonds) at the rate of R After tax SPDA accumulation – After tax loan repayment = [(1+R) 2 (1-t) + t] – [1 + R(1-t)] 2 = R 2 t (1-t)

16. Università Bocconi, A.A: 2005-2006 16 Mec – Comparative public economics 16 Clientele-based arbitrage: example Tax exempt bonds: Ra = 7% Fully taxable bonds: Rb = 10% Implicit tax rate = (.1-.7)/.1 = 30% Investor with marginal rate equal to 40% Other income $100,000 Borrow $100,000/.1 = $1,000,000 Invest in tax exempt bonds to earn $70,000

17. Università Bocconi, A.A: 2005-2006 17 Mec – Comparative public economics 17 Outline Implicit taxes Clienteles Arbitrage Restrictions and frictions

18. Università Bocconi, A.A: 2005-2006 18 Mec – Comparative public economics 18 Restrictions and frictions Symmetric uncertainty Information asymmetry –Hidden action Capital markets: high interest rates on unsecured borrowing Labour market –Hidden information Lemons’ problem in tax driven mergers Conflicts between financial reporting and tax planning