Taxation and liquidity.

• Author: Listokin, Yair

ARTICLE CONTENTS INTRODUCTION I. ASSET PRICES AND LIQUIDITY A. The Theoretical Basis for a Tradeoff Between Returns and Liquidity 1. Illiquidity Premium in Absolute Returns but Not in Residual Returns 2. Illiquidity Premium in Absolute and Residual Returns B. Supply and Demand in the Market for Liquidity C. Empirical Evidence for the Relationship Between Illiquidity and Return 1. Cross-Sectional Evidence 2. The Value of Liquidity in Nearly Identical Assets a. Restricted Stock b. Treasury Bills Versus Treasury Notes D. The Importance of Liquidity in the Economy II. THE PRICE AND QUANTITY OF LIQUIDITY IN THE PRESENCE OF INCOME TAXES A. The Impact of Income Taxes on the Illiquidity Premium when Investors Are Risk-Neutral 1. The Illiquidity Premium Changes when Income Taxes Are Introduced 2. Income Taxation and the Price and Quantity of Liquidity B. The Impact of Income Taxes on the Illiquidity Premium when Investors Are Risk-Averse and Illiquidity Costs Are Correlated with Aggregate Risk 1. Illiquidity Supply and Demand with Fully Deductible Illiquidity Costs and Fully Adjustable Investment Portfolios--Domar-Musgrave for Illiquidity 2. Illiquidity Holdings with Partially Deductible Illiquidity Costs 3. Illiquidity Holdings with Partially Deductible Illiquidity Costs, Costly Portfolio Rebalancing, and Late-Arriving Income Tax Refunds for Illiquidity Costs III. INEFFICIENCIES CAUSED BY THE TAXATION OF ABSOLUTE RETURN AND THE PARTIAL NONTAXATION OF LIQUIDITY A. The Size of the Financial Sector 1. Overproduction of Nontaxable Banking Services Rather than Interest 2. Securitization a. The Benefits of Securitization b. The Costs of Securitization c. Amounts of Securitization and Taxation 3. Public Equity Trading a. The Benefits of Public Trading b. Costs of Becoming a Publicly Traded Company c. Publicly Traded Companies and Taxation 4. The Size of the Financial Sector and the Production of Liquidity B. Clientele Effects and the Nontaxation of Liquidity 1. Tax Status as a Determinant of Liquidity Holdings 2. Why Do University Endowments Hold Illiquid Assets? Tax Motivations in Addition to "Long-Term Horizons" IV. THE TAX STATUS OF ILLIOUIDITY IN BROADER PERSPECTIVE: INCOME TAX FEATURES BENEFITING ILLIOUIDITY AND OTHER "SOLUTIONS" TO THE TAX ASYMMETRY BENEFITING LIQUIDITY A. The Role of Existing Income Tax Features in Increasing or Reducing the Distortions in the Market for Liquidity 1. The Realization Requirement and Preferential Capital Gains Rates 2. Corporate Taxation B. Deductions for Illiquidity Costs C. Taxing Imputed Income from Liquidity 1. Imputation of Income from Liquidity 2. A Wealth Tax as a Tax on the Imputed Income from Liquidity 3. Other Ex Ante Income Taxes as Solutions to the Asymmetric Taxation of Liquidity and Illiquidity CONCLUSION INTRODUCTION

Asset returns depend upon the liquidity of a security. (1) Cash, for example, yields no financial return, but investors are nevertheless willing to hold cash as part of their portfolios. Cash provides transaction services, enabling investors to consume quickly and easily. The connection between liquidity and asset returns demonstrates that the standard model in which asset returns are determined by a tradeoff between risk and return is, at best, incomplete. Indeed, the liquidity/return tradeoff provides a better explanation for the behavior of asset prices during the financial crisis of 2007-2009 than standard risk/return based theories can offer. (2)

Tax scholars have examined the implications of risk/return tradeoffs for the appropriate taxation of assets for over fifty years. (3) Scholars have also examined the impact of imputed income from real assets, such as housing, on the ownership of real versus financial assets. (4) The tax academy has almost entirely overlooked, however, the tax implications of the liquidity/return tradeoff. (5) This Article begins an examination of the interaction of an income tax on individual investors with the liquidity/return tradeoff. (6)

Suppose that an investor faces a choice about the type of assets that she should hold. The investor can hold cash and receive no return or hold assets in an illiquid form, such as real estate, and earn 10% interest annually. If the investor holds cash, then she pays for consumption with cash. If the investor holds real estate, then she pays for consumption with a credit card (she has no cash) and pays 10% interest on her credit card borrowings. Without an income tax, the investor is indifferent between holding cash or holding illiquid real estate. Either holding enables her to purchase the same amount of consumption and leaves the same amount of wealth. Cash yields no return, but it obviates the need to use a credit card and to pay interest to purchase consumption. This benefit offsets cash's lack of return.

Under the federal income tax, however, the investor's preferences change. If income taxes are 50%, then the investor pays income tax equal to 5% of the value of the real estate (50% of real estate's 10% return) but no income tax on cash. Moreover, the interest paid on credit card debt cannot be deducted. (7) After taxes, holding real estate no longer enables the investor to purchase the same amount of consumption as holding cash does. As a result, the investor prefers to hold cash rather than real estate.

This example demonstrates how income taxes distort the choice between liquid and illiquid assets. The extent of the distortion depends upon the tax treatment of the costs of illiquidity and the benefits of liquidity. In the example, the investor prefers cash to illiquid assets because part of cash's "return" (in the form of malting purchases cheaper and easier) goes untaxed, while the extra consumption costs (having to pay credit card interest) associated with real estate are nondeductible.

The size and direction of the distortion between liquid and illiquid assets depend upon the income tax treatment of the costs associated with converting illiquid assets into consumption. If either the costs associated with illiquidity are fully deductible (for example, deductibility of credit card interest) or the benefits associated with liquidity (ease of buying consumption) are taxed, then the tax code does not distort the choice between liquid versus illiquid assets. But the most reasonable characterization of the U.S. income tax does not meet either of these conditions. (8) The benefits associated with liquidity go untaxed while the costs of illiquidity are deductible only sometimes. As a result, the income tax distorts investment choices toward liquid assets and away from illiquid assets. The size and scope of the distortions depend upon the characteristics of the market for liquidity, including how much liquidity costs to supply and how valuable liquidity is to investors.

The tax preference for liquidity potentially explains a portion of the proliferation of securitization in the economy. While it is very costly to sell an individual asset such as a mortgage, it is much cheaper, under many circumstances, to sell a securitized package of assets. (9) Securitization enhances liquidity, creating a market for packages of assets that does not exist for individual assets. Securitization also entails costs, however, such as the moral hazard created when those issuing mortgages no longer bear the entire default risk of the mortgage. Theory predicts that securitization should occur when its benefits in the form of liquidity (and risk diversification) exceed its costs. If the liquidity benefits of securitization are untaxed while the higher returns of illiquid unsecuritized assets are taxed (and the costs associated with this illiquidity cannot be fully deducted), then assets will be oversecuritized.

Securitization is simply one way in which the financial sector produces liquidity. Securitization, public equity markets, and many other elements of financial intermediation facilitate connections between buyers and sellers of capital, thereby making capital exchange more rapid and less expensive--and thus more liquid. If such liquidity goes untaxed, then it will be overproduced and the financial sector will become overgrown as one of its primary outputs--liquidity--is tax-favored. (10) By contrast, other features of the income tax that favor illiquidity, such as the realization requirement, reduce the size of the financial sector.

The asymmetric taxation of liquid and illiquid assets also distorts the identity of the owners of assets--a distortion known as a clientele effect. Without taxation, patient asset-holders who are unlikely to need liquidity should hold illiquid assets while those more likely to need cash should hold liquid assets. Because of the asymmetric taxation of liquid and illiquid assets, however, low-rate taxpayers collect rents from holding high-return illiquid securities, encouraging them to hold these securities regardless of their cash needs. Tax preferences, along with the oft-argued notion of "long-term horizons," may explain some part of why untaxed university endowments disproportionately hold illiquid high-yielding assets.

After examining the inefficiencies caused by asymmetric taxation of liquid and iIliquid assets, I consider possible solutions to these distortions. The asymmetry could be eliminated in one of two ways. Either the costs of illiquidity could be made more easily deductible, or the benefits of liquidity could be taxed. Which approach is better depends upon the appropriate definition of income. If we view liquid assets as providing imputed income in the form of transaction services, then the benefits of liquidity should be taxed. If, however, we view the costs of illiquidity as properly deducted to determine net income, then the costs of illiquidity should be deductible.

Under either view, the asymmetry of taxation between liquid and illiquid assets should be eliminated. If the appropriate definition of income requires subtraction of the costs of...