Market Bubbles and Wasteful Avoidance: Tax and Regulatory Constraints on Short Sales
Although short sales make an important contribution to ﬁnancial markets, this transaction faces legal constraints that do not govern long positions. In evaluating these constraints, other commentators, who are virtually all economists, have not focused rigorously enough on the precise contours of current law. Some short sale constraints are mischaracterized, while others are omitted entirely. Likewise, the existing literature neglects many strategies in which well advised investors circumvent these constraints; this avoidance may reduce the impact of short sale constraints on market prices, but may contribute to social waste in other ways. To ﬁll these gaps in the literature, this paper oﬀers a careful look at current law and draws three conclusions. First, short sales play a valuable role in the ﬁnancial markets; while there may be plausible reasons to regulate short sales — most notably, concerns about market manipulation and panics — current law is very poorly tailored to these goals. Second, investor self-help can ease some of the harm from this poor tailoring, but at a cost. Third, relatively straightforward reforms can eliminate the need for self-help while accommodating legitimate regulatory goals. In making these points, we focus primarily on a burden that other commentators have neglected: proﬁts from short sales generally are ineligible for the reduced tax rate on long-term capital gains, even if the short sale is in place for more than one year.
Powers, Michael R.; Schizer, David M.; and Shubik, Martin, "Market Bubbles and Wasteful Avoidance: Tax and Regulatory Constraints on Short Sales" (2003). Cowles Foundation Discussion Papers. 1682.