Taxing New Financial Products: A Conceptual Framework

Abstract

A recent wave of innovation in the financial markets has raised difficult tax policy questions. Professor Strnad describes several frameworks for designing tax rules for new financial products and shows that two types of existing approaches, bifurcation and integration, can create tax systems that are universal, meaning that the system assigns a tax treatment to every transaction, and consistent, meaning that changing the form of the transaction will not affect that treatment. In particular, Professor Strnad shows that the spanning method, a particular bifurcation approach, can create a consistent and universal tax system if the system is also linear. Constraints created by the current tax system's treatment of certain types of assets, however, prevent the spanning method from providing a practical solution to the problems posed by the taxation of new financial products. Professor Strnad also shows that integration schemes can provide universal and consistent tax systems, even if those systems are nonlinear. Still, discontinuities in the current tax law limit the ability of integration schemes to solve all of the problems created by financial innovation. As a result, Professor Strnad concludes that, in the absence of a major congressional overhaul of the tax laws, policymakers should prescribe tax rules for new financial products on a case by case basis.