Economics and Economic Substance

Abstract

The economic substance doctrine has no basis in economics. The fact that a transaction has an after-tax profit but not a pretax profit is not an indication of inefficient resource allocation. Nor does economic analysis suggest that denying tax benefits to arrangements lacking economic substance will reduce the deadweight loss of taxation. Because a pretax profit requirement has no economic foundation, it is irrelevant whether the calculation of pretax profit takes account of implicit taxes. Both the conventional definition of economic substance based on pretax profit and competing formulations that give less or no weight to pretax profit appear to be based on reverse engineering to isolate features that unappealing transactions in high-profile litigation have shared. All these formulations fail to answer the critical questions surrounding the economic substance doctrine: why lack of economic substance is intrinsically bad, and why intrinsically bad transactions are more likely to lack economic substance. Some supporters of the doctrine concede its lack of economic logic but defend it based on its practical effectiveness. This line of defense is generally based on anecdotes unconnected to the actual content of the doctrine and fails to explain why a pretax profit test should be a relatively effective means of targeting objectionable transactions