Chapter

Implicit Taxes and Clienteles,

Arbitrage, Restrictions, and
Frictions

Key Words / Outline

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 12

TAXES
Implicit taxes arises because the prices of investments that
are bid up in the marketplace.
As a result, the before-tax rates of return on tax-favored
instruments are lower than those on tax-disfavored
investments.
Taxes are paid implicitly through lower before-tax rates of
return on investment.
To calculate implicit taxes requires a benchmark assets
against which to compute pretax returns.
Here, benchmark asset is an asset whose returns are taxed
fully each year at ordinary rates. That is, tax is not deferred
on any part of the economic gain that accrues from holding
the asset. A fully taxable bond that is default-free, with its
interest rate set to market rates each period, is such an
asset.

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 13

TAXES

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

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 14

TAXES

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

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 15

TAXES
Example of Implicit Taxes
The lower pretax rates of return on tax-exempt
municipal bond (MB) relative to fully taxable
corporate bond (CB) of comparable risk is the most
direct and vivid illustration of the concept of implicit
taxes.
Due to tax-exemption, the investors bid up the
prices of the MB such that their pretax return is
lower than the pretax return on fully taxable CB.

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 16

TAXES
How Accelerated Depreciation Deductions Affect Pretax
Required Rates of Return
Depreciation allowances on PPE (property, plant & equipment) reduce taxable
income.
The more accelerated the depreciation schedule, the closer the taxpayer
comes to expressing the cost of the investment immediately and the more taxfavored the investment.
Example: Say, Cost of investment (C) = $100,000; Taxpayers marginal tax
rate (t) = 40%; After-tax rate of discount (r) = 9%.
If an immediate deduction of the entire cost of the investment is allowed, the
reduction of tax (i.e., at n = 0) = $100,000 x 40% = $40,000.
If the depreciation schedule = straight-line over 2 years and the taxpayer is
allowed to deduct $50,000 at the beginning of first year and $50,000 at the
beginning of second year, then the after-tax present value of depreciation
deduction is:

$50,000 x 40% + $50,000 x 40%

(1 + 9%)0
(1 + 9%)1

= $38,349

which is $1,651 less than an immediate deduction ($40,000) of the full cost.

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 17

TAXES
How Tax Credits Affect Pretax Required Rates of Return
Investment tax credit is granted on the purchase of certain equipment equal
to a fraction of the assets purchase price. This investment tax credit is
usually coupled with the depreciation deduction, and then the tax benefit is
more liberal.
A tax credit is like a tax receipt.
Generally, a tax credit is more valuable than a deduction. Whereas tax credits
reduce taxes dollar for dollar, deductions reduce taxes by a fraction equal to
the tax rate.
If the investors marginal tax rate today is tp0, marginal tax rate in n year tpn,
the project generates no cash flows until time n, at which time it generates (1
+ R)n dollars so that the pretax rate of return on investment per period is R,
the investment period n years. The after-tax return per dollar of after-tax
investment (r) is:
$1(1 + R)n(1 tpn)
(After-Tax Return)/(After-Tax Investment) =
$1(1 tp0)

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 18

TAXES
How Tax Credits Affect Pretax Required Rates of Return
(After-Tax Return)/(After-Tax Investment) =

$1(1 + R)n(1 tpn)

$1(1 tp0)

contd

. (5.1)

If tp0 = tpn = 40%, R = 8%, n = 5 years, then because the taxpayer deducts the
investment cost, a $1 investment today has an after-tax cost of $1(1 tp0) = $.60. At the
end of 5 years, the investor retains $.882 [= $1(1+.08)5(1.40)] per dollar invested. The
5-year after-tax return per dollar invested is $1.469 [=$.882/$.60]. The after-tax return
per year is 8%, or 1.4691/5 1.
Thus, in the special case of constant-across-time tax rates (tp0=tpn), the pretax return
(R) and the after-tax return on investment are the same. With constant tax rates,
equation (5.1) simplifies to (1+R)n. It means the after-tax rate of return per period is R
thus, the return is tax-exempt.
And in equilibrium, the required pretax rate of return, R, on the project must be equal to
the after-tax bond rate, rb. Note that this rate is exactly the required rate of return on
tax-exempt municipal as well.

5.1 TAX-FAVORED STATUS AND IMPLICITSlide 19

TAXES
Effect on equation (5.1) when the marginal tax rates change over time
If the tax rates were expected to fall (i.e., tpn < tp0), the required R would be less than
the after-tax bond rate, rb.
If the tax rates were expected to increase (i.e., tpn > tp0), the converse would be true
(i.e., the required R would be more than the after-tax bond rate, rb).
For example, assume that tp0 = 40%, tpn = 30%, n = 5 years, then the after-tax bond
rate, rb is 7%.
On a risk-adjusted basis, in equilibrium, the cumulative n-year after-tax return for this
investment and a fully
taxable bond must be the same:
$1(1 + R)n(1 tpn)
n
$1(1 tp0)

That is, R =

(1 + rb)n(1 tp0)
(1 tpn)

. (5.2)

(1 + rb)

1/n

1=

(1+.07)5(1.40)
(1 .30)

1/5

= 3.75%
A before-tax required rate of return of 3.75% is well below the after-tax return on bonds of 7%.

Slide 15.2 THE IMPLICIT TAX RATE, THE EXPLICIT

TAX RATE, AND THE TOTAL TAX RATE10
Holding taxes constant, the required rate of return on a risky
bond exceeds that of a less risky bond because, for the same
amount of promised coupons and principal repayment, the
prices of bonds with a high risk of default are lower than the
prices of bonds with a low risk of default.
Because we wish to isolate the effects of differential tax
treatments on required before-tax rates of return (R), we must
adjust the R on bonds for differences in risk.
We use the term risk-adjusted to indicate that we are
comparing returns on alternative investments after adjusting for
risk differences.
After isolating the effects of differential taxation on R, risk and
nontax-cost differences have been introduced into the analysis.

Slide 15.2 THE IMPLICIT TAX RATE, THE EXPLICIT

TAX RATE, AND THE TOTAL TAX RATE11
Computing the Implicit Tax: The implicit tax on the returns to any asset is
defined as the difference between the pretax return on the benchmark security
and the risk-adjusted pretax return on the alternative asset.
Benchmark asset: Implicit tax comes in the form of reduced pretax income
from investors bidding up the price of tax-favored assets to garner the favorable
tax treatment. But what constitutes favorable tax treatment is all relative and
requires a benchmark asset for comparison. Fully taxable bond, which is defaultfree, is usually taken as the benchmark asset.

Example: Assume that pretax return on fully taxable bonds is 10% and that the
risk-adjusted pretax return on tax-exempt bonds is 7%.
The implicit tax on tax-exempt bonds would then be 3% (=10% 7%).
The implicit tax on fully taxable bonds is zero.
If we define Rb as the risk-adjusted pretax return on fully taxable bonds (the
benchmark asset) ) and Ra as the risk-adjusted pretax return on alternative
investment, the implicit tax rate (tIa) is given by:

Rb(1 tIa) = Ra
or

t = (R R )/R .. (5.3)

Slide 15.2 THE IMPLICIT TAX RATE, THE EXPLICIT

TAX RATE, AND THE TOTAL TAX RATE12
Computing the Implicit Tax:
Substituting for Rb = 10% and Ra = 7% in Eq. 5.3,
tIa (implicit tax rate on municipal bonds) = (10% - 7%)/10% = 30%.
Thus, paying tax at a rate of 30% on fully taxable bonds would result in a return of 7%, the
same as the pretax rate of return on tax-exempt bonds.
Although investors do not pay any explicit tax on the interest earned from holding municipal
bonds, they pay the tax implicitly at 30% tax rate through a lower pretax rate of return.

To whom is the implicit tax paid?

In case of tax-exempt municipal bond example, the implicit tax is paid to the issuers of the
tax-exempt securities.
The issuing municipalities receive an implicit subsidy by way of a lower cost of capital. In the
example, the subsidy is at the rate of 30% of normal (that is, fully taxable) borrowing costs.
This taxing scheme, which uses implicit taxes to subsidize municipal spending programs, is
similar to an alternative scheme in which all bonds, including municipal bonds, are fully
taxable at the federal level and the federal government remits the tax collected on municipal
bonds to each issuing authority. In this alternative setting, the pretax return on municipal
and fully taxable bonds would be 10%. Whether the bond was labeled a municipal or a
taxable bond would make no difference to investors.

Slide 15.2 THE IMPLICIT TAX RATE, THE EXPLICIT

TAX RATE, AND THE TOTAL TAX RATE13
Total Tax Rates in a Competitive Market:
The total taxes paid on any investment is the sum of implicit taxes plus explicit
taxes, where implicit taxes are measured relative to some benchmark asset.
In a competitive equilibrium, with no tax rule restrictions and frictions, the riskadjusted after-tax returns on all assets must be equal. Otherwise, arbitrage
opportunities exist. This common after-tax return is denoted by r*.
Explicit Tax of any asset = difference between its pretax and after-tax returns
= Ra ra.
Implicit Tax of any asset = difference between pretax return on benchmark
asset and the pretax return on the asset in question = Rb Ra.
Total tax = Implicit tax + Explicit tax = (Rb Ra) + (Ra r*) = Rb r*.
Total tax is the same for all assets.
Total tax rate = Implicit tax rate + Explicit tax rate
= (Rb Ra)/Rb + (Ra r*)/Rb
= (Rb r*)/Rb

Slide 15.2 THE IMPLICIT TAX RATE, THE EXPLICIT

TAX RATE, AND THE TOTAL TAX RATE14
Table 5.1 (p. 100)

Fully Taxable
Bond

Partially
Taxable Bond

Tax-Exempt
Bond

Pretax return

Rb = 10%

Ra = 8%

Re =7%

Implicit tax

Rb Rb = 0%

Rb Ra = 2%

Rb Re = 3%

0%

20%

30%

Rb r* = 10%
7% = 3%

Ra r* = 8%
7% = 1%

Re r* = 7%
7% = 0%

Explicit tax rate =

Explicit tax/Rb

30%

10%

0%

Total tax = Implicit

tax + Explicit tax

3%

3%

3%

30%

30%

30%

Implicit tax rate =

Implicit tax/Rb
Explicit tax

Total tax rate

Slide 15.3 THE IMPORTANCE OF ADJUSTING FOR

15
RISK DIFFERENCES
It is important to adjust for differences in risk to avoid incorrect
calculation of the tax effects on the returns to assets.
Alternatively stated, the tax planner could incorrectly estimate the
implicit and explicit tax rates on assets, leading to incorrect
decisions about, for example, which assets to invest in.
The focus here is on the question of why to adjust for risk, not
how to derive the adjustment for risk.
The capital asset pricing model (CAPM) is used in the text to derive
the required pretax risk premium.
The CAPM can be written as: E(Rj) = Rf + j[E(Rm) Rf],
where j = cov(Rj, Rm)/ 2(Rm).

Slide 15.3 THE IMPORTANCE OF ADJUSTING FOR

16
RISK DIFFERENCES
Notations used to facilitate the discussion of Risk Adjustment:
R = pretax rate of return
r = after-tax rate of return = R(1 t)
Ro = required (or observed) pretax total rate of return (including risk and
tax effects)
Rrp = required pretax risk premium on some risky asset
Rra = risk-adjusted required pretax risk premium on some risky asset = Ro Rrp
rrp = required after-tax risk premium on some risky asset = Rrp(1 gt)
then Rrp = rrp/(1 gt).
where g = % of pretax return from the asset that is included in taxable income.
rra = risk-adjusted after-tax rate of return on some risky asset = Rra(1 gt)
= r* in equilibrium, which further implies that Rra = r*/(1 gt).
For a fully taxable bond, g = 100% = 1 (all the income is taxable at ordinary rates);
For a tax-exempt bond, g = 0% = 0 (none of the return on the bond is taxable);
For a partially taxable asset, 0<g<1 (a fraction of the income is taxable at statutory rates).

Slide 15.3 THE IMPORTANCE OF ADJUSTING FOR

17
RISK DIFFERENCES
Ignoring Risk Differences

Fully Taxable
Bond (Asset b)
Required
Pretax
return (Ro)

Rb=20%

Table 5.2 (p. 101)

Partially Taxable
Bond (Asset a)
Ra=12%

Tax-Exempt
Bond (Asset m)

Rm = 12% = r*

Explicit tax (20% 12%)/20% (12% 12%)/20% (12% 12%)/20%

rate (te)
= 40%
= 0%
= 0%

Implicit
(20% - 20%)/20% (20% - 12%)/20% (20% - 12%)/20%
= 40%
tax rate (ti) = 0%
= 40%
Total tax
rate (t)

40%

40%

40%

Slide 15.3 THE IMPORTANCE OF ADJUSTING FOR

18
RISK DIFFERENCES
Adjusting Risk Differences
Fully Taxable
Bond (Asset b)
Req. pretax risk
premium (Rrp)

Table 5.2 (p. 101)

Partially Taxable Bond Tax-Exempt Bond

(Asset m)

(Asset a)

5%

2%

3%

Risk-adjusted
Pretax return (Rra)

15%

10%

9% = r*

Explicit tax rate

(15% 9%)/15%

(te)

= 40%

(10% 9%)/15%
= 6.7%

(9% 9%)/15%
= 0%

Implicit tax rate

(ti)

(15% 15%)/15% = 0%

(15% - 10%)/15%
= 33.3%

(15% - 9%)/15% =
40%

Total tax rate (t)

40%

40%

40%

g (% of return
taxable)

100%

Rra(1-gt) = r*
=>10%(1-g*40%)=9%
=> g = 25%

0%

Slide 15.3 THE IMPORTANCE OF ADJUSTING FOR

19
RISK DIFFERENCES
Discussion on Table 5.2:
Ignoring the risk difference:
Implicit tax rate (ti) is the same (40%) for both the partially taxable asset
(Asset a) and the tax-exempt asset (Asset m) even though one asset
is partially taxable and the other is tax-exempt.
Adjusting the risk difference:
Given the pretax risk-adjusted returns for each asset, the implicit tax
rate (ti) is 33.3% for the partially taxable asset (Asset a) and this is less
than the ti for the tax-exempt asset (Asset m), i.e. 40%.
This is the expected result, because the partially taxable asset (Asset a)
is less tax-favored than the tax-exempt asset (Asset m).
According to the value of g, 25% of the income from the partially taxable
asset (Asset a) is taxable, whereas the income from the Asset m is not
at all taxable.

5.4 CLIENTELES

Slide 120

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.
The clientele for an investment is the taxpayer with marginal explicit
tax rates (METR) below implicit tax rate.
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 METR below implicit tax
rate 30%. A taxpayer with 20% METR will earn 8% [=10%(120%)]
after-tax by investing in fully taxable bond, 1% greater than in taxexempt government security.

Slide 15.5 IMPLICIT TAXES AND CORPORATE TAX

21
BURDENS
Over the years, some corporations have not paid explicit taxes.
The primary reasons include:
Availability of generous depreciation deductions
Tax credits
Immediate write-offs of certain investments (such as advertising,
R&D, and certain personnel costs)
Interest expense deductions
Myriad opportunities to postpone the recognition of taxable income
Enjoyment of special tax rules by some industries (e.g., oil industry,
insurance companies).
Not paying explicit taxes can have political costs (if negative campaign
organized by any advocacy group, e.g. Citizens for Tax Justice in the USA).

But consideration of implicit taxes is usually ignored, not only by

politicians, but also in academic research studies, although the omission
is recognized by researchers), because of the difficulty in estimating
them.

5.6 TAX ARBITRAGE

Slide 122

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 tax arbitrage (OFTA)
- Clientele-based tax arbitrage (CBTA)
Guideline for arbitrage: Since the clientele for an
investment is the taxpayer with marginal explicit
tax rates (METR) below implicit tax rate, so
arbitrage will work when METR>Implicit tax rate.

5.6 TAX ARBITRAGE

Slide 123

Classification

Type of
taxpayers

Long Position in

Short Position in

Organizational-form

All taxpayers

An asset or
productive activity
through a favorably
taxed
organizational form

An asset or
productive activity
through an
unfavorably taxed
organizational form

Clientelebased

High-tax-rate
taxpayers

A relatively taxfavored asset (one

that bears a
relatively high
implicit tax)

A relatively taxdisfavored asset

(one that bears a
relatively more
explicit tax)

Low-tax-rate
taxpayers

A relatively taxdisfavored asset

A relatively taxfavored asset

Arbitrage

Tax arbitrage is prevented by tax-rule restrictions and market frictions.

5.7

Slide 1ORGANIZATIONAL-FORM ARBITRAGE24

Organizational-form Tax Arbitrage Example when there is no

restriction & friction [any taxpayers]

Salary income of Tk. 100,000 subject to marginal explicit tax rate

(METR) 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 aftertax, an amount equal to pretax salary.

5.7

Slide 1ORGANIZATIONAL-FORM ARBITRAGE25

Restrictions on Organizational-form Tax Arbitrage [no Friction]

Placing a limitation on taxpayers ability to deduct interest expense only

from taxable income out of investment of the loan (and the organizationalform arbitrage would fail to eliminate tax on salary income)

Limiting the tax-exempt balance in the savings component of a life

insurance policy relative to the insurance (or term) component. Minimum
ratios of term insurance to savings prevent taxpayers from having large
tax-exempt balances without paying a nontrivial amount for life insurance
that they might not want.

Limiting capital loss deductions from normal business income

Restraints on deducting losses resulting from transactions involving

related parties

Limiting deduction of loss under one head against income under another
head (business loss restricted for deduction against income from house
property)

5.7

Slide 1ORGANIZATIONAL-FORM ARBITRAGE26

Effects of Frictions on Organizational-form Tax Arbitrage [no Restriction]

Suppose that, because of special costs incurred to invest in a particular savings
vehicle, the taxpayer loses a fraction, f, of the pretax rate of return, R, from
the vehicle i.e., the taxpayer realizes only R(1 f) of the pretax return in the
savings vehicle.
Alternatively, the frictions might relate to special costs incurred to borrow funds
to finance other investments, in which the pretax borrowing rate becomes R(1
+ f), even when the loan is a riskless one.
In the case of investing in life insurance policies, the special costs arise, in part,
from the presence of salespeople who are paid to teach taxpayers how life
insurance policies work;
from administrative personnel, who are necessary to keep track of policies as well
as file reports; and
from auditors, who are necessary to assure policyholders that their money really is
being invested in riskless bonds or in whatever types of securities the insurance
company advertises.

5.7

Slide 1ORGANIZATIONAL-FORM ARBITRAGE27

Effects of Frictions on Organizational-form Tax Arbitrage [no Restriction]

Suppose that a taxpayer with current taxable income of Y dollars seeks to effect
organizational-form tax arbitrage (OFTA) by borrowing at rate R to invest in a
tax-exempt savings vehicle.
The tax-exempt savings vehicle, however, yields a return only R(1 f) due to the
presence of frictions.
The taxpayer must borrow Y/R at the start of the year to generate sufficient
interest deductions to reduce taxable income to zero. This move generates RY/R,
or Y dollars of interest expense, an amount equal to the income to be sheltered.
The Y-dollar amount of income is just sufficient to pay the interest on loan and
reduce taxable income to zero. The investment made with the loan proceeds
generates a return only R(1 f)Y/R, or Y(1 f), in the tax-favored savings vehicle.
Note that fY of the original Y dollars of income has been lost, not due to the tax
payment, but due to market frictions. It is as if the taxpayer paid an explicit tax at
rate f.
We can see that frictions have the same effect on investment returns as implicit
taxes.

5.8 CLIENTELE-BASED ARBITRAGE

Slide 128

Clientele-based Tax Arbitrage Example when there is no

restriction & friction [High-tax-rate taxpayers]

Salary income of Tk. 100,000 subject to marginal explicit tax rate (METR) 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 rate (ITR) on govt. security =(10%-7%)/10%=30%<METR
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.

5.8 CLIENTELE-BASED ARBITRAGE

Slide 129

Clientele-based Tax Arbitrage Example when there is no

restriction & friction [Low-tax-rate taxpayers]

Salary income of Tk. 100,000 subject to METR of 25% on first Tk. 40,000 and
40% on next Tk. 60,000, thus, tax = Tk. 34,000.
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 rate (ITR) on govt. security =(10%-7%)/10%=30%
To reduce tax liability on salary income, borrowing at the beginning of the year
for that portion of income where METR>ITR [for 40% tax-rate portion], an
amount equal to Tk. 60,000/10% = Tk. 600,000, and investing in tax-exempt
govt. security to earn Tk. 42,000 after-tax.
Tk. 60,000 salary to be used to pay Tk. 60,000 interest.
After-tax income (with borrowing or arbitrage)
= Tk. 40,000(1-25%)+Tk. 42,000 = Tk. 72,000.
After-tax income (without borrowing or arbitrage) = Tk. 40,000(1-25%)+Tk.
60,000(1-40%) = Tk. 66,000 [i.e., Tk. 6,000 less].

5.8 CLIENTELE-BASED ARBITRAGE

Slide 130

Restriction on Clientele-based Tax Arbitrage (CBTA)

Preservation of a more progressive tax-rate structure is an

automatic imposition of restrictions on CBTA at income slabs with
METR<ITR, because then the CBTA is unprofitable.
Prevention of the deduction of interest expense on loan used to
purchase certain assets that yield tax-exempt income.

5.8 CLIENTELE-BASED ARBITRAGE

Slide 131

CBTA with Investments in Tax-Favored Assets Other than

Tax-Exempt Bonds
CBTA is usually not subject to such restrictions which exist on
borrowing to buy such tax-favored investments as stocks, land,
equipment that is eligible for accelerated depreciation (AD), or a host
of other tax-favored investments.
CBTA can be effected through borrowing to purchase such tax-favored
assets, if the MTTR [marginal total tax rate (implicit plus explicit)]
reflected in market prices for tax-favored investments< the taxpayers
explicit tax rate.
Note, however, the assets that are tax-favored due to AD are not as
effective in bringing about CBTA as are tax-exemption type of shelters.
Because this CBTA requires other taxable income against which to
deduct AD; whereas income from tax-exempt bond can be used to
shift much larger amount of other taxable income from explicit to
implicit taxation.

5.8 CLIENTELE-BASED ARBITRAGE

Slide 132

Market Equilibrium with Tax-Exempt Entities

Absent restrictions, tax-exempt entities (e.g., universities and municipalities)
could profit by buying taxable bonds and selling tax-exempt bonds as long
as a positive spread remained between the rates on the two securities.
The equilibrium for tax-exempt investors requires that all assets bear zero
implicit tax, but then arbitrage opportunities would arise for taxpayers facing
positive MTRs.
Such taxpayers would buy tax-exempt municipal bonds and sell fully taxable
bonds to create sufficient interest deductions to eliminate their taxable
income.
For municipalities, one form of CBTA may be financing profit-making
ventures that they own by issuing tax-exempt securities. That is, they can
deduct the interest costs on tax-exempt securities from pretax profits and
pay tax only on the remaining taxable income (so-called unrelated business
income) at corporate rates.

End of the Chapter

Thank you.

Slide 133