Taxation and Liquidity

Article excerpt

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. …