Paul L. Caron

Friday, November 20, 2020

Weekly SSRN Tax Article Review And Roundup: Speck Reviews Nadler's Tax-Motivated Trading And Price Efficiency

This week, Sloan Speck (Colorado) reviews a new work by Hillel Nadler (Program on International Financial Systems), The Only Sure Alpha: Tax-Motivated Trading and Price Efficiency (Aug. 12, 2020).

Speck (2017)

In The Only Sure Alpha: Tax-Motivated Trading and Price Efficiency, Hillel Nadler examines tax-motived trading in financial instruments from a novel and compelling perspective: the ways in which tax rules affect the process of price discovery in otherwise well-functioning markets. Nadler argues that tax considerations may drive “noisy trading”—trading that moves prices away from an equilibrium based on non-tax information. Although markets (eventually) should resolve these deviations of price from fundamental value, Nadler notes that the noise itself may have significant and detrimental systemic effects. Transitions to equilibrium matter, and taxation may cause distortions that leave financial markets in a constant state of low-level flux.

For Nadler, the principal tax offenders mostly are the usual suspects, including the realization rule, the rate preference and limitations that apply to capital gains, and the myriad provisions governing derivates and more exotic financial products. The article’s contribution lies largely in fleshing out these features’ implications for price discovery. And Nadler’s concerns are timely. The rise of passive index-oriented mutual funds, as well as the advent of high-speed algorithmic trading, imply that tax-motivated trading exerts a growing force on financial markets. Corporate law scholars have worried about these changes for quite some time; Nadler effectively translates these concerns to taxation.

Among Nadler’s many insights are three points that I found particularly surprising. First, to the extent that loss limitations deter tax-loss harvesting, they decrease noisy trading and improve the quality of prices—a reason to hang onto these limitations, if the realization rule remains in place. Second, risk-based tax rules, such as those that govern constructive sales, may have the opposite effect. By requiring trades to change counterparties’ economic exposure to the underlying assets, these rules “effectively incentivize nosier tax-motivated trading.” Nadler posits, in a very Bittker-esque way, that these risk-based rules might be relaxed to improve market efficiency, though at some cost to fairness and administrative concerns. Third, concerns about price efficiency militate against a capital gains preference, since the preference encourages conversion plays—a species of noisy trading. By highlighting different stakes, Nadler effectively and counterintuitively reframes these longstanding structural features of the Internal Revenue Code.

In the background of Nadler’s eloquent argument reside a series of empirical questions. Nadler gives good reasons and some evidence that tax-motivated trading imposes real and substantial costs. But the rough magnitude of these costs needs to be known in order to make appropriate tradeoffs with, for example, distributional considerations or other aspects of efficiency. Price discovery may require a relatively small volume of active, tax-indifferent trading, especially in light of the last two decades’ global savings glut. If so, fiddling with the tax dials may yield a lot in terms of price efficiency, and at little cost along other metrics. From this perspective, Nadler’s argument calls more for tweaks than for comprehensive reform, and these tweaks may seem a bit thin in today’s new age of inequality.

Another potential avenue for change might eschew income taxes altogether—or, at the very least, take the income tax system as fixed. For example, financial transaction taxes could slow the velocity of trading enough to eliminate the most brazenly tax-motivated ploys. If these controversial tax instruments were better integrated into the theoretical structure of well-functioning markets (even in a second-best world), they might prove more palatable to policymakers. Although Nadler appropriately limits his analysis to the income tax realm, rangier solutions warrant further exploration.

Finally, Nadler’s article implicates questions of tax exceptionalism. Are tax costs unique, or should they be viewed as just another flavor of transaction cost? Some of the stakes are disciplinary, but others are substantive. The granular details of taxation may matter in constructing solutions that address market inefficiencies more broadly. Or taxes may be a problem that requires its own bespoke solutions. From this perspective, Nadler’s article works as a mediation on the interplay between structure and nuance in tax law—and the challenges inherent in weaving policy-driven reform between the two.

Overall, Nadler’s richly developed and detailed article provides a fresh and convincing perspective on the taxation of financial instruments. Scholars in taxation and corporate law, as well as tax policy experts in the next administration, would be well-rewarded by engaging with Nadler’s excellent analysis.

Here’s the rest of this week’s SSRN Tax Roundup:

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