SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? DAVID A. WEISBACH *

SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? DAVID A. WEISBACH * Abstract - This paper examines the Clinton Administration proposal to treat short sales against the box (and other similar transactions) as realization events. The paper concludes that traditional analysis, for example, that based on Haig Simons notions of income, cannot determine whether the proposal increases social welfare. The proposal may produce efficiency gains, but further work into the effects of lockin are needed before the gains can be determined. Finally, administrative problems with the proposal overwhelm other concerns and are not easily fixed. gain, although substantial (and difficult) empirical work is needed to verify the claim. In particular, the proposal would increase realizations but also increase the cost of lock-in. The size of these changes must be determined and translating these changes into social welfare costs requires better models of stock trading than are currently available. Third, the administrative problems with the proposal (or any proposal of this sort) are substantial and raise questions about whether it should be adopted at all, particularly given ambiguous efficiency gains. BACKGROUND This paper examines the Clinton Administration proposal to treat short sales against the box (and other similar transactions) as realization events for federal income tax purposes. The paper draws three conclusions. First, traditional analysis, for example, that based on Haig Simons notions of income or horizontal and vertical equity, cannot resolve whether the proposal would produce a net welfare gain. Second, the proposal may produce an efficiency * Georgetown University Law Center, Washington, D.C. 20001. The general rule under current law is that gain or loss is not taken into account until it is realized. While realization is not defined in the tax code (the concept was created by the courts), it generally occurs when an asset is sold or exchanged. In a short sale, the taxpayer borrows stock from a third party and sells the borrowed stock on the market for cash. The borrowed stock must be replaced when the short position is closed. If the stock price has gone down, the borrowed share can be replaced by repurchasing a share on the market for 495

NATIONAL TAX JOURNAL VOL. L NO. 3 less than the cash received from the short sale, generating gain. If the stock price has gone up, the replacement share will cost more than the cash received, generating loss. The short seller must pay the stock lender amounts equal to any dividends paid on the stock while the short sale is open. In a short against the box transaction, a taxpayer who owns stock (long stock) sells short other shares of the same stock. The taxpayer is indifferent to price movements in the stock: if the stock price goes up, the value of the short position goes down; and if the stock price goes down, the value of the short position goes up. Dividends on the stock are offset by an obligation to make equal payments to the stock lender. Thus, the taxpayer has eliminated exposure to the stock. Under most stock exchange regulations, 95 percent of the cash from a short against the box can be withdrawn and used without restriction. The tax law does not treat a short against the box as a realization event with respect to the long stock position even if the taxpayer has unrealized gain in the stock when the short sale occurs. Although the history is murky (there is no case law or statutory authority directly on point), the reason seems to be that the taxpayer literally still holds the long position in the stock. The tax law respects the two transactions (the long position and the short sale) as separate transactions rather than netting them or looking at the taxpayer s actual risk. Shorts against the box are not unique. Other transactions also allow the effective equivalent of a sale without tax. For example, an agreement to sell a stock on a fixed future date for a fixed price eliminates the risk of loss and opportunity for gain from the stock but is not treated as a sale of the stock. 1 Regardless of the future price of the stock, it will be sold for the price set in the contract. If the contract is cash settled, meaning that the difference between the fixed price and the actual stock price on the sales date is paid in cash, the effect is the same. Any increase in the price of the stock is offset by an obligation to make a payment on the contract, and any decrease in the price of the stock is offset by the right to receive a payment on the contract. The only difference with actual delivery is that the taxpayer must effectively repurchase the stock on the settlement date for its fair market value. And if the contract is for the exchange of the stock for a fixed number of units of some other property, the effect is to expose the taxpayer to risk from the other property and eliminate risk on the stock. A so-called equity swap is a series of cash-settled contracts of this sort. Equity swaps have received as much or more publicity as shorts against the box and (despite the title of this article) are probably an equal motivating factor behind the Administration s proposal. In the contracts to sell described above, the taxpayer retained the risk that dividend payments would change before the exercise date of the contract. Dividend risk, however, can easily be, and is often, eliminated. For example, the payments on an equity swap are usually adjusted to account for any interim payments (such as dividends) on either the property held by the taxpayer or the property that the taxpayer will receive. Under the Administration s proposal, a taxpayer would recognize gain (but not 496

SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? loss) if he engages in a constructive sale. A constructive sale is any transaction that substantially eliminates the upside and downside of owning stock, a debt instrument, a partnership interest, or certain trust instruments, through a position in substantially identical property. Shorts against the box and equity swaps would be constructive sales. But buying an option to sell the stock, which protects the taxpayer from risk of loss, would not be a constructive sale because the taxpayer still has the opportunity for gain. The Administration s justification for the proposal is that it is inappropriate for taxpayers to be able to dispose of the economic risks and rewards of owning appreciated property without realizing income for tax purposes. This statement merely asserts its own conclusion; without more, it is insufficient. Nevertheless, most people s strong intuition is that the proposal, in some form, has merit. Most of these transactions are substantially tax motivated. In fact, one prominent practitioner has admitted that the only reason for shorts against the box is to avoid tax while achieving the equivalent to a sale (Kleinbard, 1993). Recent publicity of some large transactions has shown that realization has become effectively elective for the truly wealthy. 2 TRADITIONAL RATIONALES Traditional legal scholarship has focused on concepts, such as the Haig Simons definition of income, ability to pay, and horizontal and vertical equity, to support its conclusions. This scholarship has been criticized in recent years as lacking normative content. Nevertheless, discussion of the Administration s proposal is generally couched in this language, and it is worth examining these rationales to see if they help justify the proposal. The intuition underlying the Administration s proposal is that these transactions look like sales for all but tax purposes, and, because the realization rule taxes sales, they avoid the realization rule. It would be anomalous for Congress to enact a law that taxes sales but to allow such easy avoidance. Feld (1991), in making a similar proposal, argues that the proposal would help make the tax law reflect reality. This argument, however, is circular. The proposal would redefine the realization requirement. The argument in support of the proposal is based on a reference to the definition itself. One cannot determine the appropriate scope of the realization doctrine without reference to the norms that underlie realization. Realization is typically justified because of valuation and liquidity concerns. Publicly traded stock, however, is both liquid and easily valued, and a short against the box transaction does not substantially change the reasons (or lack thereof) for realization. A similar rationale is that constructive sales are economically like sales and should be treated like sales for tax purposes. This is a horizontal equity argument. Under current law, two taxpayers in the same position (they own appreciated stock) are taxed differently because one actually sells the stock and the other engages in a short against the box. Horizontal equity demands that like taxpayers, or like transactions, should be taxed alike. Some have argued that horizontal equity arguments have no merit, but, even if one assumes that horizontal equity arguments have force, the argument does not work in this context. The argument assumes that there are two taxpayers, one who sells and one who engages in a constructive sale, and 497

NATIONAL TAX JOURNAL VOL. L NO. 3 claims they should be treated the same. Suppose there is a third taxpayer who also owns appreciated stock but who continues to hold it (without any offsetting transactions). For example, X has stock with basis $40, value $100 and sells it for cash; Y has stock with basis $40, value $100 and enters into a short against the box; and Z has stock with basis $40, value $100 and holds it unhedged. Horizontal equity demands that all three be taxed the same because all three have the same income, $60. Treating the short against the box either as a realization event or not creates inequity with either the seller or the holder. Y cannot be the same as both X and Z. If degrees of horizontal equity are allowed, it is unclear which result (treating short against the box as a realization event or not) produces more equity. For example, if there are 50 Z s and only one X, it is unclear whether treating Y like Z or like X improves horizontal equity. This is the familiar second best efficiency argument applied to equity. The above analysis treats people as relevantly alike if they have the same income. From a realization viewpoint, however, their cash flows look different. Arguably, the seller, X, and the holder, Z, are not relevantly alike, but the seller, X, and the hedger, Y, are. Horizontal equity, however, cannot be satisfied in this sense either. The argument is the same except that the baseline is cash flows instead of income one can always identify a fourth person, say, W, who is not covered by the proposal but who has cash flows similar to Y s cash flows. Treating Y like the seller, X, just creates an inequity between Y and W. For example, the Administration s proposal requires elimination of substantially all the upside and downside of owning stock. Transactions that fall just short of this standard (a large proportion of the upside and downside are eliminated, but not substantially all) will not trigger realization. Similarly, borrowing against the stock will not trigger realization under the proposal. Any proposal of this sort will leave other similar transactions taxed differently. Schenk (1995) suggests that the deciding principle in this case is to move taxpayers closer to economic income. This response is insufficient. It assumes that Haig Simons is an ideal worth achieving even if doing so would violate other norms. For example, the change might move the tax system closer to Haig Simons tax but violate horizontal equity. A violation of Haig Simons, however, cannot be balanced against these other norms because Haig Simons has no independent worth. It is entirely derivative of other notions, such as ability to pay, horizontal equity, or efficiency. A final consideration is the effect of the proposal on vertical equity. Supporters claim that the proposal will ensure that the rich pay their fair share of capital gains taxes and, therefore, the proposal enhances vertical equity (Quinn, 1995; Sheppard, 1995; Norris, 1995). Shaviro (1995) argues the opposite: proposals of this sort will increase taxes on middle income taxpayers while leaving the truly rich no worse off and, therefore, have poor distributional consequences. To my knowledge, a distributional analysis of the proposal has not been performed. My suspicion is that Shaviro is generally correct, but only those with substantial wealth will find it worth the costs to avoid the proposal. That is, measured on most scales of progressivity, the proposal will make the tax system more progressive. 498

SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? Vertical equity is an appropriate consideration but cannot be the sole support for the proposal. Assuming that the tax burden should be made more progressive, other proposals may have similar effects (for example, just changing the rate structure). Criteria other than vertical equity, such as efficiency, must be used to decide between proposals that shift the tax burden similarly. EFFICIENCY ARGUMENTS An alternative to the traditional arguments is to examine whether the proposal would make the tax system more efficient. The realization doctrine generally has not been discussed from an efficiency perspective. The primary literature in this area discusses the effect of the tax rate on the realization of capital gains, taking the definitions of realization and capital gains as fixed. These definitions, however, are not fixed. The definition of realization and capital gains themselves, not just the effect of the tax given the definitions, can be analyzed from an efficiency perspective. Shaviro (1992) is, to my knowledge, the only author to discuss the definition of realization from an efficiency perspective. Shaviro analyzes the costs of the realization doctrine by breaking down the effects into two stages: the initial investment and the decision to sell. A narrow definition of realization may cause distortions in investment decisions toward assets that can easily avoid the rule. Broadening the definition of realization may reduce this inefficiency. A broad definition, however, may cause distortions on decisions to sell assets, as realization will be relatively unavoidable. The net effect will depend on the context. Before turning to detailed arguments, consider the following simple efficiency argument in favor of the proposal. Constructive sales achieve the economic equivalent of a sale while deferring taxes. If deferral is a good thing, it can be allowed directly without the need for the transactions costs of a constructive sale. Thus, a policy of allowing direct deferral dominates a policy of allowing deferral through constructive sales. Either we should allow direct deferral or we should tax constructive sales, but we should not allow deferral through constructive sales. While direct deferral would reduce transactions costs, it would also reduce tax revenues. Thus, allowing direct deferral would require raising distortionary taxes on some other activity, and the inefficiency under current law may not be more than the distortions caused by the other taxes. Similarly, taxing constructive sales may increase revenue, but may cause inefficient changes in behavior. Thus, a closer examination is needed. I will follow Shaviro s example and break the analysis into the initial investment and the decision to sell, beginning with the decision to sell. Decision to Sell The most important cost of the realization requirement is the lock-in effect. The realization requirement causes taxpayers to retain assets beyond when they otherwise would sell because selling is taxed but holding is not. There is a large literature attempting to measure the size of this effect. Most of the literature, however, focuses on whether reducing tax rates will increase realizations sufficiently to raise revenue. The analysis here needs to focus on the change in social welfare caused by the 499

NATIONAL TAX JOURNAL VOL. L NO. 3 change in the lock-in effect resulting from the proposal. An increase in the capital gains rate increases lock-in because it increases the cost of selling relative to holding or hedging. The Administration s proposal has the opposite effect. The only way to avoid realization will be to hold stock without hedging it (or use imperfect hedges designed to avoid the proposed rules). The effective cost of avoiding realization is increased, which will lead to increased realizations, or a decrease in lock-in. The proposal will cause some people to sell who otherwise would not. For those who do not sell, however, the lock-in effect will cause more harm because perfect hedges will no longer be available without tax. Thus, the proposal will reduce lock-in, but also increase the potential harms of what remains of the lock-in effect. The most common models measuring the costs of the lock-in effect assume that any failure to trade due to taxes produces a welfare loss. Individuals engage in mutually beneficial exchanges and welfare is measured by the sum of their utilities. By reducing beneficial exchanges, realization taxes reduce their utility and, therefore, aggregate welfare. One could apply this analysis to determine the efficiency of the constructive sale proposal. I believe, however, that this would be too simplistic. If there are market imperfections, what appears (at least from an ex ante perspective) to be mutually beneficial trading may produce ex post social losses, or at least make the effect more ambiguous. In this case, simple ex ante welfare functions may not be appropriate measures. For example, Holmstrom and Myerson (1983) argue that interim or ex post measures may be more appropriate in some circumstances. The likelihood of market imperfections may depend on the motive for trading. I will consider four distinct reasons for trading: diversification, speculation, risk hedging, and consumption. Diversification Financial theory suggests that individuals should own diversified portfolios and, depending on their degrees of risk aversion, some risk-free assets. In a world without transactions costs, there is no lock-in effect because all individuals own identical portfolios (but vary in their percentages of risk-free assets). In the real world (still assuming individuals desire to hold optimally diversified portfolios), perfect diversification is not possible because of transactions costs, and individuals will trade occasionally to rebalance their portfolios. Lock-in will cause individuals to have less than optimally diversified portfolios. The effects of the proposal in this model should be minimal. A wide variety of methods exist to balance portfolios that will not trigger realization under the proposal. For example, options trading generally will not produce tax under the proposal and can be used to rebalance the portfolio. Similarly, trading based on industry factors can rebalance a portfolio without triggering tax. In addition, if risk preferences change (so that the portion of assets held in a diversified portfolio changes), the risk of the portfolio can be adjusted through portfolio hedges without creating a constructive sale. Nevertheless, compared to current law, the proposal makes rebalancing more difficult, and, to the extent the proposal raises the costs of diversification, it produces social losses. 3 500

SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? Speculation A second reason people trade is because they disagree with the market s assessment of the expected future performance of an asset. A seller might, for example, expect the stock to go from $100 to $95 in the next year. A buyer might expect it to go from $100 to $105. Arguably, much, if not most, trading is motivated by such disagreements (Stout, 1995). The marginal effects on welfare of this trading are ambiguous. The trading is not coerced and, therefore, many assume, mutually beneficial. But the buyer and seller cannot both be right. Next year, the stock will be either $105 or $95 and one or the other will be disappointed. Any gain to the winner is a loss to the loser. And when transactions costs are taken into account, speculative trading produces net losses. If the cost of the trade is $2, the winner will take home $4, and the loser will lose $6, creating a net of $2 in losses to the parties. The parties engage in this type of trading because they have imperfect information both as to future prices and their relative skill in trading. When there is imperfect information of this sort, pure ex ante expectations are not a good measure of social welfare. 4 Even if speculation produces losses to the traders, these losses might be offset if speculation produces better asset prices (allowing better allocation of resources) and liquidity. Economic theory often portrays speculators as investors in superior information, ensuring that mispriced goods are brought back to their true values. There is, however, theoretical reason to question whether the public benefits from improving price accuracy outweigh the private costs of speculation (for example, rent seeking) (Hirshleifer, 1971). More significantly, recent literature explores the possibility that at least some speculators who trade on what they believe to be superior information may be mistaken in that belief (Black, 1986; De Long et al., 1989; De Long et al., 1990a; De Long et al., 1990b; Shleifer and Summers, 1990). If so, such speculation cannot be assumed to produce more accurate asset prices, and may even produce prices different from true asset values. 5 Moreover, it is also unclear how much, if any, speculative trading is needed to provide sufficient liquidity for other types of trading. Thus, it is possible that the overall costs of speculation significantly outweigh the benefits. If speculation dominates the market, the social costs of lock-in may be substantially different from the sum of ex ante utility loss of locked-in traders. The Administration s proposal might have an effect on speculation, because an individual who wants to sell a stock for speculative reasons will want to eliminate the risk from the stock. Hedges that eliminate risk are the type covered by the proposal. Those that were previously hedging so that they could speculate without tax will either sell or cease to hedge. There will be an increase in actual sales for speculative reasons and a decrease in hedges for speculative reasons. The new sellers were probably hedging before, so there may be no increase in speculation from these sales (in fact, there may be a decrease because of the additional taxes), and those that hold without hedging will speculate less. Thus, the proposal might reduce speculation. 6 Risk hedging Another reason to trade is that some individuals might bear a given risk more 501

NATIONAL TAX JOURNAL VOL. L NO. 3 cheaply than others. Risk hedging allows the market to allocate the risk efficiently. For example, the profitability of a business might be tied to the strength of the dollar relative to the yen. Others may be able to absorb this risk more cheaply than the business. Trading in yen allows a transfer of this risk. Risk hedging produces welfare gains because both parties are better off when risk is allocated more efficiently. The proposal will probably have little or no effect on risk hedging, because this type of hedging will not be covered by the proposal. Consumption A final reason to sell stock is to consume. While most justifications for reducing lock-in assume that gains will be reinvested, much gain is probably consumed (Johnson, 1992). The proposal will have an ambiguous effect on consumption. It will increase sales, which may increase current consumption, but it will also make it more difficult for those who do not sell to consume currently because many hedges will no longer be available (without tax). Without a hedge, the owner of the stock may not be able to withdraw the same amount of cash for consumption as with a hedge. For example, normal margin requirements limit borrowing to 50 percent of the value of the stock (and the borrowing will increase risk), while someone who sells short against the box can withdraw 95 percent of the value. Whether the net effect reduces social welfare depends on models of appropriate savings in society. For example, there may be market failures that cause too little saving. Summary Any proposal that affects lock-in potentially affects all the types of trading described above. There is no simple method of distinguishing the speculative trader from one who is imperfectly diversified from one who is a risk hedger. Moreover, the social costs and benefits of these types of trading are still unclear. And the net effect of the Administration s proposal on trading (when hedging, as well as actual sales, is taken into account) is ambiguous. Nevertheless, the Administration s proposal in a rough sense targets trading that is most likely to be speculative (by targeting trading in individual stocks), while allowing broad-based risk hedging, which is less likely to be speculative. For example, a taxpayer who wants to adjust the relative riskiness of a diversified portfolio can do so by using positions in broad-based market indexes without triggering gain in any of the underlying stocks. 7 Thus, in a rough sense, the proposal might impose low social costs relative to the revenue raised. Initial Purchase The premise of the Administration s proposal is that the covered transactions are a unique method of avoiding realization. That is, other than the identified transactions, it is difficult to avoid realization with equally favorable economic consequences. If this is true, the proposal might cause more uniform taxation, leading to better investment decisions. That is, if there are two assets, one for which transactions such as short against the box are available and one for which they are not, treating short against the box as a realization event will make the tax system more neutral in the choice of these assets. The size of this effect is likely to be small. Moreover, the proposal primarily applies to stock. Shaviro argues that, 502

SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? because of the double tax on corporate income, applying realization and recognition rules to shareholders may [] at times be unambiguously bad, rather than a tradeoff.... That is, the proposal might make distortions worse with respect to the initial decision to invest, because stock will be taxed at a still higher rate relative to other assets. Expanding the definition of realization at the shareholder level, however, will reduce the incentives on corporations to retain earnings. For example, a Haig Simons tax at the shareholder level would eliminate the incentive to retain earnings. Expanding realization reduces but does not eliminate the incentive. Other distortions, such as the incentive for debt financing, may increase, but the net effect is theoretically uncertain and must be measured empirically. ADMINISTRATIVE PROBLEMS The real difficulty with the proposal is that it is complex and potentially unadministrable. The proposal requires lining up long and short positions and measuring the degree of risk reduction. In any complex portfolio, both these tasks are difficult. While fully exploring the complexities and implementation of the proposal is beyond the scope of this paper, a few simple examples illustrate some of the problems. Example: X owns 1,000 shares of ACo stock, each with a basis of $40, value $100. X writes 1,000 options on the stock, giving the buyer of the options the right to buy the stock for $95 anytime during the next six months. 8 If each of the options is treated as a hedge of a single share of stock, then X has eliminated the upside on the stock and hedged some of the downside (by receiving the option premium). One might think the transaction is not a constructive sale, because X retains substantial risk that the price of the stock will go below $95. The constructive sale proposal, however, does not specify the time period for which risk must be eliminated. During the six-month period, X retains substantial risk, but, during a one-day period (or one-hour period), X has effectively eliminated risk. The chance that ACo stock will go below $95 in a short period becomes vanishingly small, which means the option effectively insulates X from risk during some period. As X has eliminated upside and downside risk, X has engaged in a constructive sale. It is possible to fix this problem, but it is not easy. Picking a period of required risk reduction would be inconsistent with the underlying intuition behind the proposal treating transactions that are like sales as if they were sales because a taxpayer who actually sells a stock and buys it back is taxed on the gain regardless of the period between the sale and the repurchase. Moreover, enforcing the rule would require consideration of replacement hedges. For example, if the required hedge period is one month, taxpayers could fully hedge for a month less a day, close the hedge, and replace it one hour later. Tracing these types of hedges would be difficult. Suppose that the time period problem is fixed. The transaction still might be a constructive sale. The value of the options will vary with the value of the stock, but not usually in a one-to-one relationship. Suppose that, within a range of prices, every $1 movement in the value of the stock is matched by a $0.60 change in the value of the option. Then, if the options are treated as hedging 600 shares (rather than the 1,000 shares assumed above), X is fully 503

NATIONAL TAX JOURNAL VOL. L NO. 3 hedged (for some time period, which may be longer than the required time) and has engaged in a constructive sale of the 600 shares. There is no reason to prefer lining up the options to shares on a one-to-one basis (which would not result in a constructive sale), or on a ten-to-six basis (which might result in a constructive sale), or to any intermediate characterization. But, without an ability to line up the options with specific shares, the proposal cannot be applied. Example: X owns 1,000 shares of stock of ACo, each with a value of $100. X purchases an option to sell the shares in six months for $95 each and writes an option for a third party to buy the shares from him for $105. It is unclear whether this transaction is a constructive sale. X retains risk and opportunity within a narrow range (between $95 and $105) but has eliminated risk outside this range. If a particular range is determined to be a constructive sale, the transaction can be tailored to fall just outside that range. Moreover, determining a range is difficult. A fixed percentage of the value of the stock might be a simple method of setting a range, but, because stocks have different volatilities, a fixed percentage of value would measure a different degree of risk reduction for different stocks. A more precise volatility measure would be difficult to administer. There are numerous other complexities related party rules, portfolio hedges, exotic derivatives, etc. The list goes on. Consider how simple the first transaction was holding stock and selling a call option and how complex the problems are. Modern financial instruments, however, are substantially more complex than selling an option. While fairness and efficiency gains are uncertain, in my view, the complexities of the proposal probably overwhelm any potential gains. There are two possible responses. The first is to narrow the proposal to cover only the simplest transactions. For example, the proposal could be narrowed to treat only short sales against the box and equity swaps as constructive sales. Equivalent transactions would not trigger gain. This is the approach taken by a proposal introduced by Rep. Kennelly. 9 The advantage of this approach is that it is relatively simple while capturing the most important, most common transactions. For some, the costs of avoiding the proposal will not be worth the gains. The disadvantage is that, for those who have much to gain, it is easily avoidable, and, therefore, a proposal of this sort may raise little revenue while causing substantial behavioral changes. The other alternative is to broaden the proposal so that almost any hedge would meet its requirements. Because the proposal would be relatively unavoidable, determining whether it applies arguably might be less complex. I do not, however, believe this approach will reduce complexity. The straddle rules take this approach they apply to any transaction that substantially diminishes risk of loss and yet are among the most complex provisions in the Internal Revenue Code. There is no reason to believe a broad constructive sale provision would be less complex. Conclusions The efficiency gains of the proposal are uncertain and depend on views of stock trading. Given uncertain efficiency gains, administrative concerns dominate. Designing an administrable proposal is difficult. In my view, the best 504

SHOULD A SHORT SALE AGAINST THE BOX BE A REALIZATION EVENT? approach is to narrow the proposal along the line of the Kennelly proposal. Should other transactions that avoid the proposal become as common as short sales against the box or equity swaps are currently, they can be added later. ENDNOTES I thank Gerry Auten, Steve Cohen, Viet Dinh, Avery Katz, Bill Paul, Steve Salop, and Lynn Stout for comments. 1 The investor retains the risk that interest rates will change before the forward contract is settled. 2 For example, in a well-publicized transaction, members of the Lauder family, through the use of short sales, sold about $385 million of Estee Lauder stock in an initial public offering, without paying any tax on their gain. The transaction was unusual because of its size, because it was an initial public offering, and, most importantly, because the stock sold short was borrowed from related parties. Related party short sales are particularly troubling. If a husband can borrow stock from his wife (or child from parents, subsidiary corporation from parent corporation, etc.) and sell it short, couples can dispose of all stock without tax and without increased transactions costs. 3 The issue is substantially more serious with respect to entrepreneurs who own highly concentrated blocks of stock and want to diversify. If these individuals are a concern, specific relief can be crafted. In fact, Sections 1202 and 1244 of the tax code already include some relief for entrepreneurs. 4 For example, fraud and casinos both involve imperfect information. Purely adding expected utilities of the parties to fraudulent transactions or gambling transactions will produce a poor measure of the social benefit from these transactions. 5 Arbitrage might limit this potential, but, for arbitrage to be profitable, the price eventually has to move as the arbitrager predicts. If other speculators prevent prices from reflecting fundamental values, the arbitrager who bets on fundamental values will lose. Thus, it is unclear whether speculation produces the social benefits by ensuring accurate prices. 6 This is not to say that the proposal is an ideal or even a good vehicle for limiting the social costs of stock trading. 7 It is often assumed that proposals such as the Administration s proposal will lead to increased risk (for example, see Shaviro, 1995). The simplistic version of this argument is that hedges reduce risk, the proposal taxes some hedges, and, therefore, the proposal reduces hedging and increases risk. There is, however, no connection of this sort between the proposal and the overall level of risk. The cash from a short against the box or other constructive sale can be invested freely and may well be invested in risky assets. The proposal might, however, affect risk because it changes the capital gains tax, which affects risk. A pure Haig Simons tax on capital would increase risk taking (Stiglitz,1969). To the extent gains and losses, and income and capital, are treated asymmetrically in a realization tax, the effect is ambiguous. Selective realization allows acceleration of losses relative to gains, but the loss limitations effectively tax losses at a lower rate than gains. Existing models are uncertain about the net effect, particularly because the effect of transferring risk to the government is unclear. The proposal reduces the deferral of gains, so it will affect the incentives to take risk, but whether it moves in the right direction is unknown. 8 I thank Bill Paul for this example. 9 Since the drafting of this paper, both houses of Congress have passed tax bills that unlock provisions substantially identical to the Kennelly bill. REFERENCES Black, Fischer. Noise. Journal of Finance 41 No. 3 (July, 1986): 529 543. De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann. The Size and Incidence of the Losses from Noise Trading. Journal of Finance 44 No. 3 (July, 1989): 681 96. De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann. Noise Trader Risk in Financial Markets. Journal of Political Economy 98 No. 4 (August, 1990a): 703 49. De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann. Positive Feedback Investment Strategies and Destabilizing Rational Speculation. Journal of Finance 45 No. 2 (June, 1990b): 379 95. Feld, Alan L. When Fungible Portfolio Assets Meet: A Problem of Tax Recognition. The Tax Lawyer 44 No. 2 (Winter, 1991): 409 43. Hirshleifer, Jack. The Private and Social Value of Information and the Reward to Inventive Activity. The American Economic Review 61 No. 4 (September, 1971): 561 74. Holmstrom, Bengt and Roger B. Myerson. Efficient and Durable Decision Rules with Incomplete Information. Econometrica 51 No. 6 (November 1983): 1799 1819. 505

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