Faculty Bibliography

Similar investments are often taxed differently, rendering our system less efficient and fair. In principle, fundamental reforms could solve this problem, but they face familiar obstacles. So instead of major surgery, Congress usually responds with a Band-Aid, denying favorable treatment to some transactions, while preserving it for others. These loophole-plugging rules have become a staple of tax reform in recent years. But unfortunately, they often are ineffective or even counterproductive. How can Congress do better? As a case study, we analyze Section 1260, which targets a tax-advantaged way to invest in hedge funds. This analysis is especially timely because a multi-billion dollar litigation is pending about this rule. This Article proposes a three-step approach. First, when faced with a new type of tax planning, policymakers should decide whether a response is really necessary. How harmful is the transaction? How feasible is it to target this transaction without also burdening “good” transactions, which don’t involve the same abuse? This first phase determines what we call “the normative presumption” about the transaction. Second, Congress should define which transactions are potentially problematic. An “initial filter” should exempt transactions that clearly don’t pose the relevant concern. Third, once a transaction is deemed to be potentially problematic, a sophisticated test is needed to check whether it actually is. Admittedly, a sophisticated test is costly to administer. This is why initial filters are needed to limit how often it is used. Along with proposing this three-part framework, this Article offers a novel critique of a sophisticated test the government has begun using: a “delta” test, which measures how closely investments track each other. Although delta is often considered the gold standard, we show how easy it is to manipulate. The trick is to add contingencies (e.g., so the investment terminates when the price reaches a specified level). To head off this gaming, we recommend an alternative test that focuses on value instead of on changes in value–and, more generally, on enduring features instead of temporary quirks.

The debate between rational models of behavior and their systematic deviations, often referred to as “irrational behavior”, has attracted an enormous amount of research. Here, we reconcile the debate by proposing an evolutionary explanation for irrational behavior. In the context of a simple binary choice model, we show that irrational behaviors are necessary for evolution in stochastic environments. Furthermore, there is an optimal degree of irrationality in the population depending on the degree of environmental randomness. In this process, mutation provides the important link between rational and irrational behaviors, and hence the variety in evolution. Our results yield widespread implications for financial markets, corporate behavior, and disciplines beyond finance.

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.

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.

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.

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.

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.

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.

As part of its proposal for comprehensive tax reform, the House Ways and Means Committee has suggested mark-to-market taxation for derivatives, but apparently not for the underlying assets. Such a partial mark-to-market system would create opportunities for investors to have negative effective tax rates and thereby extract billions of dollars from the U.S. Treasury on an annual basis. I explain the nature of such strategies, develop the underlying theory, and provide specific empirical examples of how they would have worked if the proposed regime had been in place historically. I also describe revisions to the reform proposal that would address the concerns that I raise. In light of my findings, I suggest that Congress either abandon or substantially revise the current proposal.

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.

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.

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.

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.

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.

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.

The American Jobs Creation Act of 2004 (AJCA) provided a limited-time tax deduction for U.S. firms repatriating accumulated foreign earnings as cash dividends, and I study this natural experiment in corporate cash shocks. Consistent with theories of imperfect capital markets, firms did not use newly freed cash to return value to shareholders but instead increased acquisitions. Firms with strong management also increased executive compensation. In addition, firms raised debt and sold property to fund repatriations. Markets anticipated firm behavior, and firms ultimately choosing to repatriate were penalized in advance by a significant drop in value when the AJCA was enacted.