Three things that I'd like to acknowledge:
High-level insights from the lecture:
Taxes shape behavior explicitly by decreasing demand for investments that are taxed relative to those that are not, and implicitly by increasing the cost (lowering yield) of those investments that are not taxed.
In addition to investment choices, organizational form arbitrage and clientele-based arbitrage are ways that taxes shape behavior.
Let's think about the following situation:
Yes, you read that right. If you lend money to the U.S. Government, they tax the interest that they pay you, but they do not let the states tax you (that makes sense, you didn't earn that money in the state where you live).
The reverse is also true, so:
Now, what is important here is that we have a real example with different tax rates on similar investments. Not the details of the U.S. tax system, which is insane. Examples like this are harder to come by in more sensible tax regimes like Hong Kong :)
So we have two bonds (corporate, and US Federal) with two yields, taxed at two rates.
Corp. Bond Pretax Yield: $r_{B}$ Taxed at $t_{F}$ then $t_{S}$.
US Treas. Bond Pretax Yield: $r_{T}$. Taxed at $t_{F}$.
So if $r_B=r_T$ which do you prefer?
$$r_{B'}=r_{B}(1 - t_{F})(1 - t_{S})$$or
$$r_{T'}=r_{T}(1 - t_{F})$$It depends on $t_S$.
If $r_B=r_T$ and $t_S=0$ then $r_{B'}=r_{T'}$
So for investors that are located in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming there is no difference between the two.
But for most of the population of the US $t_S>0$ so $r_{B'}<r_{T'}$!
This difference in yields caused by the impact of tax-favored status is called an implicit tax.
where the benchmark is an investment with the same risk.
The higher are state taxes, the more attractive Treasury securities become. Demand for Treasuries pushes their yield down. This example is an illustration of tax clienteles. It also shows that ignoring implicit taxes leads to overestimation of the risk premium applicable to corporate debt.
Coupon | Maturity | Price | Yield | |
---|---|---|---|---|
Amoco Aaa/AAA | 8.625 | 12/2016 | 105.953 | 8.060 |
U.S. Gov | 7.5 | 11/2016 | 99.4375 | 7.55 |
Ignoring the differences in risk, the implicit tax is:
$$\frac{8.060-7.55}{8.060}=6.3\%$$Questions:
Progressive tax rates increase with income.
How progressive are tax rates? The answer you reach depends on where you look for evidence.
By considering the sum of explicit and implicit taxes paid by each taxpayer, it becomes apparent that substantial implicit taxes are often paid by high tax rate taxpayers in place of explicit taxes that would be even greater.
Thus, tax rates are more progressive than an examination of tax returns would suggest, but less progressive than enacted tax rates would suggest.
The erosion of the progressivity in enacted tax rates depends upon the nature and availability of differentially taxed assets that investors facing varying marginal taxes may choose to trade.
The process of taking a long position in an asset or activity through a favorably taxed organizational form, and a short position in an through an unfavorably taxed organizational form.
If there are no limits on organizational form arbitrage, then all taxes can be eliminated.
Suppose you anticipate salary income in the future which you wish to shelter from tax.
High-tax-rate organizations take long positions in tax-favored assets (these assets bear implicit taxes), and short positions in tax-disfavored assets (explicitly taxed).
Low-tax-rate organizations take the opposite positions.
If there are no limits on clientele-based arbitrage, then all taxpayers must face the same marginal rate of tax, namely zero!
The strategy used by taxpayers who would otherwise have taxable income is as follows:
Fill in the table. Notice that tasks which lend themselves to tabular comparisons, especially when we only need to consider a few outcomes, are where Excel really shines.
However, we always need to be attentive to Excel's ability to hide errors.
How do optimal investment strategies change as a function of tax rates, lengths of investment horizon, and age?
Focus on the timing of cashflows and the payments avoided.
Fill in the table. Notice that tasks which lend themselves to tabular comparisons, especially when we only need to consider a few outcomes, are where Excel really shines.
However, we always need to be attentive to Excel's ability to hide errors.
How do optimal investment strategies change as a function of tax rates, lengths of investment horizon, and age?
Focus on the timing of cashflows and the payments avoided.