Tax Code Helped Cause Financial Crisis: Analyst

Published July 1, 2009

A new economic theory points to differences in government taxes on businesses as a major contributor to the boom-and-bust nature of economies.

Sam Eddins, director of research at IronBridge Capital Management, has developed what he calls the “tax arbitrage feedback theory” (TAFT) to help explain how the tax code affects how economic resources are allocated, and in particular how differences in the tax treatment of various market choices lead investment to where it may not be best utilized.

“Tax policy has clearly played a major role in misaligning the incentives that drive economic activity,” writes Eddins in Tax Arbitrage Feedback Theory, a paper published online by The Heartland Institute. “TAFT explains how the subtle effects of differential tax rates for various market participants produce incentives that strongly contribute to instability and boom/bust economic activity.”

Eddins argues the current global credit crisis emerged partly as a result of a poorly designed and badly managed tax system.

Government ‘Misaligned Incentives’

“The current credit crisis serves as a painful example of misaligned incentives, and reveals the potential damage and unintended consequences of an overly complex tax system,” Eddins writes. “As each market participant pursued activities that were, in their judgment, in their own self interest, system resources were misallocated, ultimately undermining our collective economic health. This happened dynamically and automatically, without any person or institution fully aware of it, or in control of it.”

Eddins also addresses the issue of credit default swaps, one of the more controversial financial instruments, which many economists argue played a role in bringing on the credit crisis. Eddins shows those swaps were influenced by tax policy.

“The purpose of debt securitization products, when viewed through a TAFT lens, is not only diversification and partitioning of risk but also tax minimization,” Eddins writes.

“Credit default swaps are revealed to be a massive tax arbitrage that shifted government tax receipts to Wall Street bonus pools and necessitated the creation of massive quantities of low credit quality debt,” Eddins continues. “The structure of this trade ‘insulated’ Wall Street agents from the credit risk while allowing them to arbitrage the tax savings of their clients as long as counterparties remained solvent.”

Market Acted Rationally

The central failure of the credit crisis was not with the market, according to Eddins, and individuals in the markets acted consistently and rationally given the circumstances.

“Rather it stands as an example of the unintended consequence of a tax policy that distorted incentives within the free market system. Regulation cannot control investors from acting in their self interest,” Eddins writes.

Recognizing the inconsistencies in the nation’s tax codes and working for tax code reform to prevent such potentially disastrous economic distortions in the future should be one of the highest priorities for policy leaders worldwide, Eddins argues.

“Our tax code is rife with inconsistencies and special interest tax incentives capable of causing unintended economic disruptions. We cannot regulate ourselves out of this simple truth,” Eddins writes.

Matthew Glans ([email protected]) is a legislative specialist on insurance and finance at The Heartland Institute.

For more information …

“Tax Arbitrage Feedback Theory,” by Sam Eddins: