Tax shelters, Dutch books, and the fundamental theorem of asset pricing.

Because the tax law makes many distinctions not based on fundamental economic differences, taxpayers can exploit these inconsistencies to create opportunities for tax arbitrage. This article argues that any interpretative system which requires consistency in the application of rules where the system itself is based on fundamental inconsistencies will always allow for arbitrage. This result applies equally to purposive interpretations of the tax law as well as to more formal or literal systems of interpretation. That is, the problem of tax arbitrage is concomitant with the existence of non-economic principles of tax law embedded in a system that interprets these rules in a consistent manner. While this idea has been applied to questions of whether a tax system can impede the ability of the economy to reach equilibrium, it has not been applied to the legal analysis of tax shelters themselves. The result of this line of reasoning is that tax shelters are the inevitable result of any tax system with inherent inconsistencies which attempts to bring an artificial consistency to these non-economic based distinctions. The article goes on to argue that one of the methods by which tax shelters are addressed by the courts is the use of inconsistent methods of applying the law to these transactions.

I. INTRODUCTION

The current U.S. income tax has many examples of inconsistent treatment of essentially identical transactions. For example, under the realization doctrine one can exchange a portfolio for one with essentially the same risk and expected return but which is composed of different securities and recognize a loss for tax purposes. If instead one continues to hold the same portfolio, the loss is not recognized (1) and the present value of the tax benefit of the losses is reduced. (2) It is the thesis of this article that inconsistencies such as this allow tax shelters to exist. If instead all income was taxed according to economic income and loss, it would essentially be impossible to create tax shelters.

One can classify tax shelters into two types: transactions which are arguably consistent with current tax law and those which clearly are not. This article will focus on those tax shelters which can be argued to be consistent with the rules. For those transactions that plainly violate the rules, the important questions revolve around the best method to encourage taxpayers to follow the tax law. This may require greater enforcement activities, or it may require a different approach to enforcement. (3) In any case, the questions relevant to these tax shelters are not addressed in this paper.

While there are a variety of definitions of tax shelters, the one used in this article is a transaction or series of transactions whose purpose is to reduce the taxes paid on the gain from other transactions. That is, these transactions shelter from tax income that has been generated from other sources. Such shelters present a problem for the tax system because of the economic waste that results from the costs associated with creating and entering into such transactions, any potential loss from the distortion of economic incentives, and of course the concomitant decrease in government revenue.

The tax law has adopted a number of approaches to such "shelters," not all of which are consistent (e.g., the economic substance doctrine). (4) This article argues that it is the inconsistency of these doctrines which prevents such shelters from gaining greater prominence. That is, the fundamental inconsistency in the tax rules has led to a matching parallel inconsistency in the legal doctrine which addresses tax shelters. The natural conclusion of this line of argument is that there is likely no potential comprehensive consistent strategy to deal with tax shelters which can be developed from the rules themselves. While it may be the case that some alterations to the rules may be helpful to reduce the number of tax shelters by making it more difficult to enter into some transactions, I would claim that any attempt to address the problem through a method of interpretation of the rules in a consistent manner is highly unlikely to succeed. However, by the adoption of a strategy which allows for the appropriate form and measure of inconsistency, the system can and has been able to continue to function.

One of the assumptions of this article is that the government will continue to utilize a tax which is more or less consistent with an income tax as a major source of revenue. That is, we will continue to have a tax system where gains are taxed and losses are permitted to offset gains on other transactions. While there may be limits on the utilization of losses, this article assumes that these limits will clearly be the exception to the rule. (5)

The article will proceed in three parts. The first part discusses the connection between the notion of "Dutch books" and the theorem commonly referred to as the Fundamental Theorem of Asset Pricing. This part discusses the manner in which the inconsistency of preferences or of prices results in the potential for arbitrage. The second part of the article connects these ideas to tax shelters by explaining that tax shelters are a form of arbitrage. This part goes on to demonstrate that a tax system can easily allow for tax arbitrage. This is based on the proposition that, for any income tax system in which items that are economically identical are taxed at different rates and not all persons are subject to the same tax rules, there will always be the potential for arbitrage of the tax system. While this proposition has been applied to the question of whether the tax system affects the financial market's ability to reach equilibrium, it has as yet not been applied to the analysis of the optimal legal approach to tax shelters. Finally, Part III discusses why we do not observe arbitrage schemes commonly operating in the world and argues that the tax system already utilizes the same mechanisms which individuals use to avoid being arbitraged in order to prevent the spread of tax shelters. In particular, there are two main methods. The first is the operation of market pricing mechanisms. The second is the adoption of matching inconsistent preferences to place limitations on arbitrage. The article concludes by demonstrating the manner in which the tax system addresses tax shelters essentially mirrors the methods by which individuals avoid being arbitraged.

II. DUTCH BOOKS AND THE FUNDAMENTAL THEOREM OF ASSET PRICES

A. Dutch Books and Arbitrage

One important requirement of the standard analysis of general equilibrium is that there are no arbitrage opportunities. (6) That is, for a general equilibrium to exist under standard economic analysis, it must not be possible for markets to be arbitraged. Because we do not observe significant levels of arbitrage, it is generally assumed that markets operate in a fashion that prevents arbitrage opportunities from arising. (7) In particular, it is assumed that the preferences of individuals are such that arbitrage is generally not possible. (8) A cornerstone of this analysis is the so-called Dutch book argument. The argument runs that, where an individual holds inconsistent preferences, there will always be a possible Dutch book or series of transactions which will generate a profit from the inconsistent preferences of the individual, without actually improving the welfare of the individual. (9) The basic notion of a Dutch book can be illustrated using a simple example. Imagine that there are three possible goods: A, B, and C. If there is an individual (Individual 1) whose preferences can be represented as A [>] B [>] C [>] A, (10) with some minimal increment in between each step (say $1), then (without loss of generality) if Individual 1 possesses A and some additional assets, another individual (Individual 2) could arrange a series of transactions to derive a profit from Individual 1 without transferring anything of value. The series of transactions would begin with Individual 2 transferring good C to Individual 1 in exchange for good A and $1, and then transferring good B to Individual 1 in exchange for C and $1. Finally, Individual 2 would then transfer good A back to Individual 1 in exchange for good B and $1. In this case, Individual 1 will be back to owning A, but will have $3 less wealth. (11) This is a simple example of a Dutch book. (12) The standard conclusion from this line of analysis is that individuals must not have inconsistent preferences, or else we would commonly see the existence of such arrangements.

B. Inconsistency and Arbitrage

The standard definition of arbitrage is the interposing of transactions which generate a current positive cash flow but which have a value of zero at all times in the future. (13) That is, in a simple two period model, an arbitrage generates a positive cash flow in period one and no net positive or negative flow in the second period. (14) Effectively, a Dutch book strategy is a type of arbitrage. That is, it is series of transactions by which one can make a profit without transferring any real value or taking on any risk. (15)