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Thursday, October 18, 2018

Guess Who Caused the Cum-Ex Tax Scandal?

In the last 24 hours, several European media outlets have boasted breaking news about the tax scandal of the century. A German journalist network is credited with uncovering gigantic "tax fraud" involving banks from several European countries, and at least one American bank. 

The trumpets of public outcry are already hard at work to create an image of greedy banks robbing grandma of her pension and her grandchild of his education. One German media outlet calls the banks "Steuerräubern", tax robbers.

In reality, this "cum-ex" scandal (the term referring to a specific stock trade practice) has a hardly-surprising origin: a burdensome tax on stock dividends, and stupid, bureaucratic regulations attached to it.

Before we get to the details, let us first of all note the obvious: 

a) regulations - no matter how onerous - are there to be followed; and
b) taxes - no matter how costly - are there to be paid.

If we don't like regulations and taxes, we either work to change them through legislation, or we avoid the economic activity that they interfere with. 

The latter, of course, happens a lot. Taxes and regulations stifle otherwise productive economic activity, slow down economic growth and discourage inventions and entrepreneurship. They also distort economic activity: when people do not outright throw in the towel in the face of regulatory and taxation costs, they spend a lot of time and resources finding ways to be able to do business anyway. 

An expert in financial economics once said that the biggest driver of financial inventions is not the pursuit of profit, but the burdens that government imposes on the industry. This is a frightening thought: more money and brainpower goes toward making it possible just to do business with profit, than toward doing business with more profit. Whether this is true or not from a scholarly viewpoint is less important; anecdotally, though, there is no doubt that people whose job it is to make money will try to do so in the headwind of almost any government onslaught. 

One has to wonder how much better the world would be if all the money we spend on trying to alleviate the heavy burden of government, was instead directed toward productive business endeavors. 

The cum-ex scandal is a case in point. This so-called scandal has to do with a form of stock trade that has been going on, in a form to evade taxes and even create fraudulent tax refunds, since at least 2000. What the news media does not report is that the German government closed the loophole in their own tax law, that allowed for this tax fraud, already in 2012.

Yet for some reason the news about this practice has just surfaced, and in a tone that gives the impression that this was just discovered. For level-headed minds, though, the background was explained in a 2017 scholarly paper by four researchers at Friedrich Alexander University in Nuremberg, Germany:
Germany imposes a withholding tax of 25% on dividend payments and credits or even refunds the tax for German as well as foreign investors. Until January 2012, two separate parties were responsible for the tax collection and the issuance of tax certificates which entitled for a tax refund or tax credit. While the withholding tax was collected by the dividend-paying corporation, the issuance of withholding-tax certificates was the responsibility of the stock holder’s depository bank. This separation of responsibilities created a lack of transparency in the withholding-tax system and opened up the opportunity for a specific type of arbitrage around dividend dates. A new form of cum-ex trades emerged which achieved issuance of withholding tax certificates without previous withholding-tax payment.
The quantitative part of the paper clearly demonstrates that the high tax rate, 25 percent, made regular cum-ex stock trade unprofitable. The only way that stock traders could make money on it was by exploiting a regulatory loophole regarding the reporting practices for dividend-tax payments. 

So long as the loophole remained in place, cum-ex trade was very popular at particular points in time. Here is how it worked:

1. Yossarian owns one share in Milo Minderbinder, Inc. On July 1, Milo Minderbinder pays dividends, $1 per share.
2. Under German tax law, with a 25-percent tax on dividends, Milo Minderbinder deposits $0.75 into Yossarian's bank account and sends $0.25 percent to a German federal government tax account. 
3. Milo Minderbinder pays the tax, but Yossarian's bank issues a certificate that the tax has been paid. 
4. Now, suppose Yossarian sells his share to Dunbar. In this case, the certificate of a paid tax is supposed to be issued by Dunbar's bank, not Yossarian's. 
5. German regulations mandate that a stock that has been sold must be delivered within two days of the sale. If the stock is traded before the date when the dividend is paid out, is is a cum-dividend stock. If it is traded right after the date, it is an ex-dividend stock.
6. Suppose now that Yossarian and Dunbar agree on trading the Milo Minderbinder stock the day before dividends are paid out. The trade regulation now stipulates that delivery can take place right after the dividend has been paid out.
7. Since the trade is agreed upon before dividend, the dividend is supposed to be paid out to Dunbar. However, Yossarian does not deliver the stock until after the dividend has been paid.
8. As a result, the stock is now priced twice: at the point of sale at P1, which takes the pending dividend payment into account; and at the point of delivery at P2, a lower price not including the just-paid dividend.
9. When Yossarian delivers the Milo Minderbinder share to Dunbar, the share is worth less than what Dunbar paid. Yossarian is therefore supposed to him the non-tax share of the dividend. 
10. However, Dunbar's bank now issues a certificate that the dividend tax has been paid. This means that Yossarian does not have to pay Dunbar the net-tax dividend. Dunbar, on the other hand, does not get the dividend but he gets a certificate that the dividend tax has been paid. 
11. Since the stock was delivered ex-dividend, he can claim a refund of the dividend tax that Milo Minderbinder paid when paying out dividends to Yossarian.

It remains to be seen how this will play out in court, but it is frankly very probable that the banks just followed the law as it was written at the time. They issued tax withholding certificates as told by government. Those same banks are now being accused of having robbed government of tens of billions of euros in taxes. In reality, what this boils down to is just another example of adaptation of economic behavior to regulations and tax laws. 

Given the government's stupidity in this particular case, it is likely that the authors of those laws and regulations have never set their foot in the industries they interfere with. But instead of exposing government incompetence, a bunch of journalists are running around with their hair on fire screaming about financial evil-doing. 

In fact, the journalists themselves do not even seem to fully understand what they are looking at. This makes it all the more important to find out the facts and details, and not to let public opinion run away in another rage wave against banks and "evil capitalism". 

What is clear already now, though, is that none of this would have happened if the German government had not combined a burdensome 25 percent tax on dividends with a reporting rule so stupid only a tax-paid bureaucrat could have come up with it. As the aforementioned scholarly paper demonstrates, as soon as reporting rules were changed, the particular interest in cum-ex trade disappeared.

And that, right there, is the real take-away from this story. Keep government out of the free market, and the free market will take care of itself.

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