Taxation and Liquidity

Abstract

One of the principal determinants of an asset's return is its liquidity-the ease with which the asset can be bought and sold. Liquid assets yield a lower return than do otherwise comparable illiquid assets. This Article demonstrates that an income tax alters the tradeoff between asset liquidity and yield because: high yields from illiquid assets are taxed; imputed transaction services income from liquidity is untaxed; and illiquidity costs are only sometimes deductible. As a result, assets have more liquidity and the price of liquidity in terms of yield is higher than it would be in the absence of an income tax. These distortions foster an excessively large financial sector, which exists in large part to create (tax-favored) liquidity. The tax wedge between liquidity and yield also creates clientele effects, in which low-rate taxpayers, such as nonprofit institutions, hold illiquid assets regardless of their liquidity needs. The liquidity/yield tax distortion also offers a new perspective on fundamental questions in federal income tax, such as the desirability of the realization requirement, preferential capital gains tax rates, and corporate taxation. These elements of the income tax mitigate or even negate the pro-liquidity tax bias identified in this Article.