Implicit Taxes

1. Implicit Taxes Key Words / Outline

2. Tax-Favored Status • Full tax exemptions • Partial tax exemptions • Tax credit, rebate, relief, and concession • Tax deduction permitted at a rate faster than the decline in economic value of the asset • Taxable income permitted to be recognized at a rate slower than the increase in the economic value of the assets cash flow

3. Tax-Disfavored Status • Special tax assessment • Tax deduction permitted at a rate slower than the decline in the economic value of the asset • Taxable income permitted to be recognized at a rate faster than the increase in the economic value of the assets cash flow

4. Explicit vs. Implicit Taxes • Explicit Tax – money taxes paid directly to tax authorities. • Implicit Tax – arises because the pre-tax investment returns available on tax-favored assets are less than those available on tax-disfavored assets. Taxpayers wishing to obtain the tax-favored treatment offered by the investment bid up the price of the investment lowering the pre-tax return. • Implicit Tax Rate – the difference in pretax returns on a given asset, and the benchmark asset (usually, “fully taxable bonds” taken as benchmark asset). Say, pretax return on fully taxable bond = 10%, and fully tax-exempted return on government security = 7%, then implicit tax rate on government security = (10% – 7%)/10% = 30%. Thus, paying tax at a rate of 30% on fully taxable bond would result in a return of 7%, the same as the pretax return on tax-exempt government security.

5. Tax Clientele • Marginal Investor: Taxpayers who are indifferent between purchasing two equally risky assets, the returns to which are taxed differently, are called the marginal investors. • Tax Clientele (inframarginal investor): Taxpayers that prefer one investment over another are referred to as the tax clientele for the preferred investment. Unless investors correctly identify their proper tax clientele, they will not maximize their after-tax rates of return. Example: Say, pretax return on fully taxable bond = 10%, and fully tax-exempted return on government security = 7%, then implicit tax rate on government security = (10% – 7%)/10% = 30%. The clientele for fully taxable bond are taxpayers with “marginal explicit tax rates” (METR) below 30%. A taxpayer with 20% METR will earn 8% [=10%(1–20%)] after-tax by investing in fully taxable bond, 1% greater than in tax-exempt government security.

6. Friction vs. Restriction • Friction – transaction costs incurred by taxpayers in the marketplace that make certain tax-planning strategies costly. • Restriction – restraints imposed by the tax authority that prevent taxpayers from using certain tax arbitrage techniques to reduce taxes in socially undesirable ways. It is these frictions and tax-rule restrictions that make potential returns to tax planning so high.

7. Tax Arbitrage • Tax Arbitrage – the purchase of one asset (a “long” position) and the sale of another (a “short” position) to create a sure profit despite a zero level of net investment. Two types of tax arbitrage: - Organizational-form arbitrage - Clientele-based arbitrage

8. Tax Arbitrage: Classification

9. Organizational-Form Tax Arbitrage • Organizational-form Tax Arbitrage – Example when there is no restriction & friction • Salary income of Tk. 100,000 subject to marginal tax rate (MTR) of 40%, thus, tax = Tk. 40,000 [=Tk. 100,000 x 40%] • Pretax interest rate on fully taxable bond=10% at which rate taxpayer can borrow unlimited quantities • Tk. 40,000 tax liability can be reduced to zero by borrowing at the beginning of the year, an amount equal to Tk. 100,000/10%=Tk. 1,000,000, and investing in a tax-exempt insurance product through a life insurance company that holds risk-free taxable bonds yielding 10%. • Tk. 100,000 salary to be used to pay Tk. 100,000 interest [=Tk. 1,000,000x10%]. • Taxable income = Salary income Tk. 100,000 – Interest expense Tk. 100,000 = zero • Tax-exempt savings from insurance policy = Tk. 100,000 after-tax, an amount equal to pretax salary.

10. Clientele-Based Tax Arbitrage • Clientele-based Tax Arbitrage – Example when there is no restriction & friction [High-tax-rate taxpayers] • Salary income of Tk. 100,000 subject to marginal tax rate (MTR) of 40%, thus, tax = Tk. 40,000 [=Tk. 100,000 x 40%] • Pretax interest rate on fully taxable bond=10% at which rate taxpayer can borrow unlimited quantities • Yield on government security = 7% tax-free • Implicit tax on government security =(10%-7%)/10%=30% • Tk. 40,000 tax liability on salary income can be reduced to zero, borrowing at the beginning of the year, an amount equal to Tk. 100,000/10% = Tk. 1,000,000, and investing in the tax-exempt govt. security to earn Tk. 70,000 after-tax. • Tk. 100,000 salary to be used to pay Tk. 100,000 interest [=Tk. 1,000,000x10%]. • Taxable income = Salary income Tk. 100,000 – Interest expense Tk. 100,000 = zero • Tax-exempt income from govt. security = Tk. 70,000 after-tax.

11. Clientele-Based Tax Arbitrage • Clientele-based Tax Arbitrage – Example when there is no restriction & friction [Low-tax-rate taxpayers] • Salary income of Tk. 100,000 subject to MTR of 25% on first Tk. 50,000 and 40% on next Tk. 50,000, thus, tax = Tk. 32,500. • Pretax interest rate on fully taxable bond=10% at which rate taxpayer can borrow unlimited quantities • Yield on government security = 7% tax-free • Implicit tax on government security =(10%-7%)/10%=30% • To reduce tax liability on salary income to zero, borrowing at the beginning of the year, an amount equal to Tk. 50,000/10% = Tk. 500,000 [for high-tax-rate portion only], and investing in the tax-exempt govt. security to earn Tk. 35,000 after-tax. • Tk. 50,000 salary to be used to pay Tk. 50,000 interest. • After-tax income (with borrowing) = Tk. 50,000(1-25%)+Tk. 35,000 = Tk. 72,500. • After-tax income (without borrowing) = Tk. 50,000(1-25%)+Tk. 50,000(1-40%) = Tk. 67,500.

12. Tax Arbitrage vs. Restriction & Friction • Tax Arbitrage may be prevented by – • Tax-rule Restrictions – placing limits by tax authority on taxpayer’s ability to deduct interest only from the income out of investment by the borrowing • Frictions – direct transaction costs

13. End of the Chapter Thank you.