An Efficiency Analysis of Line Drawing in the Tax Law

Abstract

Abstract The tax law frequently distinguishes or draws lines between economically similar activities. For example, the tax law draws lines between selling and holding, debt and equity, corporations and partnerships, and independent contractors and employees. Policy makers typically have discretion to shift the boundaries between these categories but cannot eliminate the categories or make the treatments of the categories consistent. Where a given line is drawn will have efficiency effects. This paper provides a model of efficient line drawing and gives several applications. The model shows that, generally, lines should be drawn so that a transaction or item is taxed like its closest substitutes. Moreover, the benefit of keeping substitutes together often outweighs the negative effect of raising an inefficient tax. For example, if a new financial instrument is a better substitute for equity than for debt, it should be classified as equity notwithstanding the resulting increase in the inefficient corporate tax.