February 21, 2008
Rosenzweig Presents Taxation, Risk and Derivatives: Does an Income Tax Subsidize Hedge Funds? Today at Northwestern
Adam Rosenzweig (Washington University) presents Taxation, Risk and Derivatives: Does an Income Tax Subsidize Hedge Funds? at Northwestern today as part of its Advanced Topics in Taxation Series organized by Charlotte Crane. Here is the Conclusion:
This article has begun the process of incorporating the lessons of the income taxation and risk literature into the analysis of the income taxation of financial derivatives, and primarily the use of financial derivatives by hedge funds. By looking solely at the income taxation of derivatives traded on a liquid market through this lens, some remarkable conclusions arise. Assuming a closed model with a single tax rate, full loss offsets, mark-to-market, no transaction costs and rational actors, the analysis demonstrates that the imposition of an income tax results in the government bearing speculative default risk with no offsetting market mechanism available to permit the government to offset this risk. As a result, the government effectively subsidizes the liquidity provider function of hedge funds through the imposition of the income tax; this occurs solely as a function of the role of liquidity providers as speculators and the risk allocation mechanisms of the liquid derivative markets, and not due to any asymmetric tax treatment of derivatives.
This analysis primarily implicates the understanding of the taxation of hedge funds, which are one of the largest groups of speculative investors in derivative contracts traded on liquid markets. The implications potentially become wide-ranging, however, especially once offshore hedge funds in an open system in which multiple taxing jurisdictions may be involved are taken into consideration. Although this article does not attempt to provide a comprehensive solution to the issue, it does, for the first time, utilize the income taxation and risk model to uncover the implicit efficiency and distributive costs in an income tax system with liquid derivatives markets and hedge funds – costs currently missed or underappreciated – so that such costs can be taken into account in developing a comprehensive response to the taxation of hedge funds.
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