Thomas J. Brennan

Stanley S. Surrey Professor of Law

Hauser 324

617-495-3141

Assistant: Bradford Conner / 617-496-1763

Thomas J. Brennan & Robert L. McDonald, The Problematic Delta Test for Dividend Equivalents, 146 Tax Notes 525 (2015).
Categories:
Taxation
Sub-Categories:
Taxation - Federal
Type: Article
Abstract
We present examples that show how the delta-based test of Prop. Reg. 1.871-15 can hinge upon superficial labeling of instruments rather than their underlying economics. We propose an alternative approach that eliminates the concept of a referenced number of shares and accurately reflects economic reality, but we also show how even an economically accurate test can be gamed because of administrative necessities, such as requiring that instruments be evaluated at only a single point in time.
Thomas J. Brennan, Law and Finance: The Case of Constructive Sales, 5 Ann. Rev. Fin. Econ. 259 (2013).
Categories:
Taxation
Sub-Categories:
Taxation - Federal
,
Taxation - Personal Income
,
Taxation - Corporate
Type: Article
Abstract
This review illustrates the interaction between law and finance in the particular case of the taxation of constructive sales. The focus is on the treatment of variable prepaid forward contracts and the rules regarding these instruments articulated by Revenue Ruling 2003-7 and the recent case involving Philip Anschutz (Anschutz Co. et al. v. Commissioner of Internal Revenue 2011). Simple models are used to show how the tests established by the law fail to reflect important financial considerations, such as the volatility of asset returns and the riskiness of dividend payments. These models provide examples that form the basis for a critique of the current rules and also indicate a possible path for future reform and improvement of the law, namely the addition of a delta-based test to the existing rules. The analysis presented here aims to encourage future work that applies financial theory to critique and improve legal rules in a wide range of other situations.
Thomas J. Brennan & Andrew W. Lo, Impossible Frontiers, 56 Mgmt. Sci. 905 (2010).
Categories:
Banking & Finance
,
Disciplinary Perspectives & Law
Sub-Categories:
Financial Markets & Institutions
,
Investment Products
,
Financial Reform
Type: Article
Abstract
A key result of the capital asset pricing model (CAPM) is that the market portfolio—the portfolio of all assets in which each asset's weight is proportional to its total market capitalization—lies on the mean-variance-efficient frontier, the set of portfolios having mean-variance characteristics that cannot be improved upon. Therefore, the CAPM cannot be consistent with efficient frontiers for which every frontier portfolio has at least one negative weight or short position. We call such efficient frontiers “impossible,” and show that impossible frontiers are difficult to avoid. In particular, as the number of assets, n, grows, we prove that the probability that a generically chosen frontier is impossible tends to one at a geometric rate. In fact, for one natural class of distributions, nearly one-eighth of all assets on a frontier is expected to have negative weights for every portfolio on the frontier. We also show that the expected minimum amount of short selling across frontier portfolios grows linearly with n, and even when short sales are constrained to some finite level, an impossible frontier remains impossible. Using daily and monthly U.S. stock returns, we document the impossibility of efficient frontiers in the data.
Thomas J. Brennan & Alvin C. Warren, Jr., Commentary, Realization and Lock-In When Interest Rates are Low, 152 Tax Notes 1151 (2016).
Categories:
Taxation
Sub-Categories:
Taxation - Federal
,
Taxation - Personal Income
Type: Article
Abstract
This article uses simple numerical examples to study the relationship between interest rates and the familiar problem of "lock-in" that arises from deferred taxation of unrealized appreciation. In the cases we study, lock-in comes about because of positive taxpayer borrowing costs, and realization and deferral remain significant problems for income taxation even in periods of low government borrowing rates. We also find that it is the relative size, rather than the absolute size, of the borrowing costs that matters. Specifically, lock-in prevents a taxpayer from selling an asset and buying another with a higher pre-tax return only when the incremental after-tax return increase is greater than the borrowing cost necessary to pay the tax triggered as a result of the sale. Thus the magnitude of the lock-in problem does not necessarily diminish as borrowing costs fall, but rather it depends upon a complex relationship between and among the falling interest rates, the incremental increased returns that are available, and the amount of unrealized appreciation in assets.
Ruixun Zhang, Thomas J. Brennan & Andrew W. Lo, The Origin of Risk Aversion, 111 Proc. Nat'l Acad. Sci. U.S.A. 17777 (2014).
Categories:
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Law & Public Policy
,
Law & Behavioral Sciences
Type: Article
Abstract
Risk aversion is one of the most widely observed behaviors in the animal kingdom; hence, it must confer certain evolutionary advantages. We confirm this intuition analytically in a binary-choice model of decision-making—risk aversion emerges from mindless decision-making as the evolutionarily dominant behavior in stochastic environments with correlated reproductive risk across the population. The simplicity of our framework suggests that our results are likely to apply across species. From a policy perspective, our results underscore the importance of addressing systematic risk through insurance markets, capital markets, and government policy. However, our results also highlight the potential dangers of sustained government intervention, which can become a source of systematic risk in its own right.
Ruixun Zhang, Thomas J. Brennan & Andrew W. Lo, Group Selection as Behavioral Adaptation to Systematic Risk, PLOS ONE, Oct. 2014, at 1.
Categories:
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Law & Public Policy
,
Law & Behavioral Sciences
Type: Article
Abstract
Despite many compelling applications in economics, sociobiology, and evolutionary psychology, group selection is still one of the most hotly contested ideas in evolutionary biology. Here we propose a simple evolutionary model of behavior and show that what appears to be group selection may, in fact, simply be the consequence of natural selection occurring in stochastic environments with reproductive risks that are correlated across individuals. Those individuals with highly correlated risks will appear to form “groups”, even if their actions are, in fact, totally autonomous, mindless, and, prior to selection, uniformly randomly distributed in the population. This framework implies that a separate theory of group selection is not strictly necessary to explain observed phenomena such as altruism and cooperation. At the same time, it shows that the notion of group selection does captures a unique aspect of evolution—selection with correlated reproductive risk–that may be sufficiently widespread to warrant a separate term for the phenomenon.
Thomas J. Brennan & Robert L. McDonald, Deconstructing the Taxation of Packaged Financial Strategies (Aug. 18, 2014).
Categories:
Taxation
Sub-Categories:
Taxation - Federal
,
Taxation - Personal Income
Type: Other
Abstract
Financial claims are often taxed according to the way in which they are nominally “packaged” rather than according to their economic characteristics. We deconstruct financial taxation by viewing any financial strategy as a dynamic portfolio of pure debt and pure equity. Given the taxation of these building blocks, there is a unique consistent equivalent tax treatment for any strategy, and this transparent tax is a benchmark against which burdens or subsidies due to packaging can be measured. We quantify tax effects in present value terms in the context of a partial equilibrium model. We apply our methodology to common hybrid securities, such as convertible bonds and reverse convertible bonds. We find tax-induced discrepancies of up to about up to about 6% of value (i.e., 20 basis points per year) for typical 30-year convertible bonds. With unfunded securities, such as puts and calls, the discrepancy becomes much larger in percentage terms. Because these unfunded positions are levered, however, investors do not buy as many of them, and the discrepancy in aggregate absolute terms is therefore likely not so much greater. In our framework, the discrepancy can be eliminated either by taxation based on an ongoing determination of building block equivalents or else by eliminating distinctions in taxation among the building blocks. In particular, this would require eliminating the tax distinction between debt and equity.
Thomas J. Brennan, Where the Money Really Went: A New Understanding of the AJCA Tax Holiday, (Nw. L. & Econ. Res. Paper No. 13-35, 2014).
Categories:
Banking & Finance
,
Taxation
Sub-Categories:
Economics
,
Taxation - International
Type: Article
Abstract
International tax policy debate has been informed by a belief based on prior research that, notwithstanding legal prohibitions, shareholder payouts in 2005 accounted for $0.60-$0.92 per dollar repatriated under the AJCA tax holiday. I analyze total payouts that year and prove that this is false. Additionally, I estimate actual spending changes using firm-by-firm constrained regressions over a 5-year post-holiday window. Top-20 repatriators (56% of all repatriated cash) spent heterogeneously, with $0.72 per repatriated dollar associated with AJCA-permissible uses, including cash acquisitions ($0.49), debt reductions ($0.10), and R&D ($0.09). For smaller repatriators, $0.59 per dollar was associated with permissible uses.
Thomas J. Brennan & Andrew W. Lo, Dynamic Loss Probabilities and Implications for Financial Regulation, 31 Yale J. on Reg. 667 (2014).
Categories:
Banking & Finance
,
Disciplinary Perspectives & Law
Sub-Categories:
Financial Markets & Institutions
,
Financial Reform
,
Finance
,
Empirical Legal Studies
Type: Article
Abstract
Much of financial regulation and supervision is devoted to ensuring the safety and soundness of financial institutions. Such micro- and macro-prudential policies are almost always formulated as capital requirements, leverage constraints, and other statutory restrictions designed to limit the probability of extreme financial loss to some small but acceptable threshold. However, if the risks of a financial institution's assets vary over time and across circumstances, then the efficacy of financial regulations necessarily varies in lockstep unless the regulations are adaptive. We illustrate this principle with empirical examples drawn from the financial industry, and show how the interaction of certain regulations with dynamic loss probabilities can have the unintended consequence of amplifying financial losses. We propose an ambitious research agenda in which legal scholars and financial economists collaborate to develop optimally adaptive regulations that anticipate the endogeneity of risk-taking behavior.
Thomas J. Brennan & Andrew W. Lo, An Evolutionary Model of Bounded Rationality and Intelligence, PLOS ONE, Nov. 2012, at 1.
Categories:
Legal Profession
,
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Law & Public Policy
,
Law & Behavioral Sciences
,
Legal Reform
Type: Article
Abstract
Background: Most economic theories are based on the premise that individuals maximize their own self-interest and correctly incorporate the structure of their environment into all decisions, thanks to human intelligence. The influence of this paradigm goes far beyond academia–it underlies current macroeconomic and monetary policies, and is also an integral part of existing financial regulations. However, there is mounting empirical and experimental evidence, including the recent financial crisis, suggesting that humans do not always behave rationally, but often make seemingly random and sub-optimal decisions. Methods and Findings: Here we propose to reconcile these contradictory perspectives by developing a simple binary-choice model that takes evolutionary consequences of decisions into account as well as the role of intelligence, which we define as any ability of an individual to increase its genetic success. If no intelligence is present, our model produces results consistent with prior literature and shows that risks that are independent across individuals in a generation generally lead to risk-neutral behaviors, but that risks that are correlated across a generation can lead to behaviors such as risk aversion, loss aversion, probability matching, and randomization. When intelligence is present the nature of risk also matters, and we show that even when risks are independent, either risk-neutral behavior or probability matching will occur depending upon the cost of intelligence in terms of reproductive success. In the case of correlated risks, we derive an implicit formula that shows how intelligence can emerge via selection, why it may be bounded, and how such bounds typically imply the coexistence of multiple levels and types of intelligence as a reflection of varying environmental conditions. Conclusions: Rational economic behavior in which individuals maximize their own self interest is only one of many possible types of behavior that arise from natural selection. The key to understanding which types of behavior are more likely to survive is how behavior affects reproductive success in a given population’s environment. From this perspective, intelligence is naturally defined as behavior that increases the probability of reproductive success, and bounds on rationality are determined by physiological and environmental constraints.
Andrew W. Lo & Thomas J. Brennan, Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses? An Analytical Framework, 90 Tex. L. Rev. 1775 (2012).
Categories:
Banking & Finance
,
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Financial Markets & Institutions
,
Financial Reform
,
Law & Public Policy
,
Empirical Legal Studies
Type: Article
Abstract
A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways—from minimum net capital rules to margin requirements to credit limits—the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.
Thomas J. Brennan & Andrew W. Lo, The Origin of Behavior, 1 Q. J. Fin. 55 (2011).
Categories:
Banking & Finance
,
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Financial Markets & Institutions
,
Law & Public Policy
,
Law & Behavioral Sciences
Type: Article
Abstract
We propose a single evolutionary explanation for the origin of several behaviors that have been observed in organisms ranging from ants to human subjects, including risk-sensitive foraging, risk aversion, loss aversion, probability matching, randomization, and diversification. Given an initial population of individuals, each assigned a purely arbitrary behavior with respect to a binary choice problem, and assuming that offspring behave identically to their parents, only those behaviors linked to reproductive success will survive, and less reproductively successful behaviors will disappear at exponential rates. When the uncertainty of reproductive success is systematic, natural selection yields behaviors that may be individually sub-optimal but are optimal from the population perspective; when reproductive uncertainty is idiosyncratic, the individual and population perspectives coincide. This framework generates a surprisingly rich set of behaviors, and the simplicity and generality of our model suggest that these derived behaviors are primitive and nearly universal within and across species.
Thomas J. Brennan, What Happens After a Holiday?: Long-Term Effects of the Repatriation Provision of the AJCA, 5 Nw. J. L. & Soc. Pol'y 1 (2010).
Categories:
Taxation
,
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Law & Public Policy
,
Empirical Legal Studies
,
Taxation - Corporate
,
Taxation - International
Type: Article
Abstract
This Article analyzes the long-term impact on firm behavior of the repatriation tax holiday of the American Jobs Creation Act of 2004 (AJCA). The approach taken is empirical and based on data collected from the public filings of large U.S.-based multinational corporations. Statistical analysis of the data shows that there has been a dramatic increase in the rate at which firms add to their stockpile of foreign earnings kept overseas. Further analysis shows that this change has been driven both by an increase in the fraction of foreign earnings that remain permanently invested abroad and, in the case of some categories of firms, by an increase in foreign earnings relative to domestic earnings. These findings are consistent with the hypothesis that the temporary holiday conditioned firms to anticipate future such holidays and to change their behavior by placing more earnings overseas than ever before. Thus, although the AJCA was a short-term success in getting foreign earnings repatriated, it may have been a long-term failure by creating a long-term net increase in total earnings kept overseas. The findings of this Article are useful not only for evaluating the AJCA specifically but also for demonstrating more generally the speed and degree to which behavioral effects based on conditioning can occur in the wake of a holiday or other amnesty, particularly in situations involving substantial economic stakes.
Thomas J. Brennan, Lee Epstein & Nancy Staudt, Economic Trends and Judicial Outcomes: A Macrotheory of the Court, 58 Duke L.J. 1191 (2009).
Categories:
Disciplinary Perspectives & Law
,
Government & Politics
Sub-Categories:
Empirical Legal Studies
,
Judges & Jurisprudence
,
Supreme Court of the United States
Type: Article
Abstract
We investigate the effect of economic conditions on the voting behavior of U.S. Supreme Court Justices. We theorize that Justices are akin to voters in political elections; specifically, we posit that the Justices will view short-term and relatively nit. nor economic downturns-recessions-as attributable to the failures of elected officials, but will consider long-term and extreme economic con tractions-depressions-as the result of exogenous shocks largely beyond the control of the government. Accordingly, we predict two patterns of behavior in economic-related cases that come before the Court: (1) in typical times, when the economy cycles through both recessionary and prosperous periods, the Justices will punish the elected branches of government when the economy contracts by voting less frequently for the government; and (2) in atypical times, when the economy moves into a period of deep depression, the Justices will work with the other branches of government by voting more frequently for the government. We test our hypotheses through statistical analysis of taxation opinions rendered by the Supreme Court during the period from 1913 to 1929 (a relatively normal period) and the period from 1930 to 1940 (the Great Depression). We find broad support for our hypothesis in the data we analyze, and we verify that our results are robust to a change in the measure of the economic condition as well as to a change in the specification of the regression model. We conclude that U.S. Supreme Court Justices exhibit voting patterns similar to voters in political elections when it comes to the economy.
Thomas J. Brennan, Lee Epstein & Nancy Staudt, The Political Economy of Judging, 93 Minn. L. Rev. 1503 (2009).
Categories:
Government & Politics
,
Disciplinary Perspectives & Law
Sub-Categories:
Empirical Legal Studies
,
Supreme Court of the United States
,
Judges & Jurisprudence
Type: Article
Thomas J. Brennan & Karl S. Okamoto, Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation, 60 Hastings L.J. 27 (2008).
Categories:
Taxation
,
Disciplinary Perspectives & Law
,
Discrimination & Civil Rights
Sub-Categories:
Law & Public Policy
,
Law & Economics
,
Taxation - Personal Income
,
Taxation - Federal
Type: Article
Abstract
A debate is raging over the taxation of private equity and hedge fund managers. It is being played out in the headlines, in Congress and among legal scholars. This paper offers a new analysis of the subject. We provide an analytical model that allows us to compare the relative risk-reward benefit enjoyed by private equity and hedge fund managers and other managerial types such as corporate executives and entrepreneurs. We look to relative benefits in order to determine the extent to which the current state of the world favors the services of a private equity or hedge fund manager over these other workers. Our conclusion is that private equity and hedge fund managers do outperform other workers on a risk-adjusted, after-tax basis. In the case of hedge fund managers, this superiority persists even after the preferential tax treatment is eliminated, suggesting that taxes alone do not provide a complete explanation. We assume that over time compensation of private equity and hedge fund managers should approach equilibrium on a risk-adjusted basis with other comparable compensation opportunities. In the meantime, however, our model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Education History

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Hauser 324

617-495-3141

Assistant: Bradford Conner / 617-496-1763