Question

If you are not familiar with Accounting and Taxation, please do not take this question.

Ch4 Q2

A variety of investments is available in the marketplace. What types of investors (clienteles) are most appropriate for (a) municipal bonds (b) hi growth, low dividend stocks (c) lower growth, high dividend stocks?

Chapter Summary

Different economic activities are taxed differently, even if undertaken in the same organizational form. The unequal taxation of returns affects the demand for investment and thereby affects the before-tax rates of return. Specifically, if two assets yield identical pretax cash flows, but one is more heavily taxed than the other, then the price of the more lightly taxed asset will be bid up relative to the price of the more heavily taxed asset. Absent market frictions, asset prices adjust so that the after-tax rates of return are equalized across assets for all investors in the economy. Thus, differential tax treatment of asset returns gives rise to implicit taxes. For example, those investments that are tax favored relative to fully taxable bonds earn lower before-tax rates of return than do fully taxable bonds. The difference in pretax rates of return between fully taxable bonds and the tax-favored asset is an implicit tax. That is, a tax is paid implicitly through the lower before-tax rates of return.

Investments that are tax-disfavored relative to fully taxable bonds earn higher before-tax rates of return than do fully taxable bonds, and, taking fully taxable bonds as the benchmark, the implicit tax on the relatively tax-disfavored asset is negative.

If the tax-deduction equivalents of depreciation and tax credits on an investment have a present value equal to (greater than, less than) the present value of the period-by-period decline in the market value of the investment, the required before-tax rate of return on the investment will be equal to (less than, greater than) the before-tax rate of return on the fully taxable bond on a risk-adjusted basis.

Implicit taxes are typically not paid directly to the taxing authority. The taxpayer acts as a transfer agent of sorts for the government, with the taxpayer remitting a part of the tax to the beneficiary of a governmental subsidy or transfer payment. For example, municipal bond issuers receive the implicit tax as a subsidy. Customers of goods and services produced in capital-intensive industries with liberal depreciation allowances and tax credits pay lower prices. Renters face lower rental rates when depreciation allowances are very liberal.

In comparing the returns to different assets, it is important to distinguish between risk differences and taxation differences. Risky investments are priced to provide risk premiums. A risky investment that is lightly taxed (such as common stocks) can yield a high before-tax rate of return and still bear substantial implicit tax relative to less risky assets that are fully taxed (such as taxable bonds).

If, in addition to differentially taxed assets, we have differentially taxed investors, the proper clientele for investments depends upon the mix of implicit and explicit taxes levied on the investments. The marginal investor setting prices in the market is the taxpayer who is indifferent between investing in the differentially taxed assets. The proper clientele for high-implicitly-taxed investments is investors whose statutory tax rates exceed that of the marginal investor setting prices in the market. And the proper clientele for high-explicitly-taxed investments is investors whose statutory tax rates are less than that of the marginal investor.

Investors with statutory tax rates different from the marginal investor setting prices in the market are inframarginal investors. It is the inframarginal investors who form clearly identifiable clienteles as a function of the level of implicit tax rates across investments.

Many policymakers appear to ignore implicit taxes in their public statements. If we measure the progressiveness of our tax structure by focusing exclusively on explicit taxes, the U.S. tax structure does not appear very progressive. That is, the explicit tax as a percentage of the total income is about the same for wealthy and poor taxpayers. If, conversely, implicit taxes and subsidies are incorporated into the tax-burden calculations, the tax schedule is much more progressive. The reason is that wealthy investors tend to own assets with high implicit taxes, such as municipal bonds, common stock, and real estate.

In the absence of market frictions and tax-rule restrictions, if one savings vehicle or organizational form dominated another savings vehicle or organizational form, taxpayers could eliminate all their taxes through tax arbitrage. Tax arbitrage is the purchase of an asset (a long position) and the sale of another (a short position) to create a sure profit despite a zero level of net investment.

Organizational-form arbitrage arises when taxpayers take a long position in an asset through a tax-favored organizational form and a short position in the asset through an unfavorably taxed organizational form. Clientele-based arbitrage arises when taxpayers face different tax rates and when assets are taxed differentially, which gives rise to implicit taxes. Clientele-based arbitrage is a conversion of taxable income from an explicitly taxed to an implicitly taxed form, or vice versa.

Organizational-form arbitrage can reduce the tax on income to zero over investment horizons as short as for one tax year. This requires only that the returns on the long position held through the tax-favored organizational form are taxed at a lower rate than are the losses from the short position held through another tax-disfavored organizational form.

If the organizational-form arbitrage strategy involves a long position in an asset that gives rise to deferred taxable income and a short position that yields potential tax deductions, and the tax system does not provide tax rebates for negative taxable income, organizational-form arbitrage will not reduce the tax rate on income to zero.

Asset returns can be exempt from explicit taxation either through the nontaxability of future returns (as with municipal bonds in the United States) or through immediate deductibility of investment followed by full taxation of returns. Were it not for tax-rule restrictions relating to interest deductions, tax-exempt bonds would be more effective in clientele-based arbitrage strategies than would assets that achieve tax exemption due to the deductibility of investment cost.

Market frictions impede taxpayers’ ability to undertake tax arbitrage. Most market frictions arise because information is costly and not all taxpayers have the same information. This is a point we will consider more thoroughly in the next chapter.

Many of the detailed provisions of the U.S. Tax Code represent restrictions on taxpayers’ ability to effect tax arbitrage. As numerous as these restrictions might appear to be (and they are indeed numerous; we have mentioned only a few of the more important ones here), they are far fewer in number than if there were no market frictions (that is, if implementation of tax arbitrage strategies were costless).

Answer 1

For wealthy investors, invstment in municipal bonds is appropriate as tax is not deducted from the future income generated from them. These are appropritate for persons who are ready to forego high interest to save taxation.

Investors who are young, in the higher tax bracket and earning enough to not depend upon passive income lilke dividend should invest in hi growth, low dividend stocks.

Whereas investors about to retire, falling in lower or middle tax bracket and wants some passive income also may invest in ower growth, high dividend stocks.