By Tim Edgar

Abstract
As a public policy goal, moderation of financial instability has gained considerable prominence in the face of the recent credit contraction. Not surprisingly perhaps, the role of the tax system in exacerbating instances of financial instability has begun to receive some attention in the tax-policy literature. Consistent with the general thrust of that literature, this article explores, in a very preliminary way, how some selected tax-base rule choices line up with an explicit goal of ensuring that the tax system supports regulatory and monetary policies intended to moderate financial instability. The article frames the inquiry in terms of Hyman Minsky’s “financial instability hypothesis” as an explanation of the sources of financial instability. Minsky’s work suggests how excessive leverage and risk taking arise and can be seen as defensible targets informing the choice of certain tax base rules, many of which are conventionally characterized in the tax-policy literature as efficiency-reducing concessions to revenue concerns. In this respect, the article draws on tax-expenditure analysis to reconceptualize the possible design of some of these familiar income base rules whose justification is altered somewhat when framed against Minsky’s explanation of the sources of financial instability.

More particularly, the article reviews the incomplete manner in which dividend imputation systems commonly address a tax bias in favor of corporate debt, and how this incompleteness can be justified as a means to promote maintenance of margins of safety. The article also reviews the case for and design of loss limitations, as applied to financial instruments, as well as restrictions on the deduction of interest expense under the personal income tax as a form of loss limitation. No claim is made to definitively resolve any of these base design issues; nor is there a complete canvassing of all of the possible issues whose resolution is potentially affected by a focus on financial instability. The purpose of the article is the much more modest one of suggesting how standard analyses of interest deductibility and the treatment of losses might be reframed with moderation of financial instability as a public policy goal.

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Recommended Citation
Tim Edgar, Financial Instability, Tax Policy, and the Tax Expenditure Concept, 63 SMU L. Rev. 969 (2010)