Taxation and Integrated Financial Markets: The Challenges of Derivatives and Other Financial Innovations

The past decade has witnessed the explosive growth of a multiplicity of new instruments which have altered the financial landscape. These transactions have highlighted many of the inconsistencies, asymmetries and shortcomings of current tax practices and challenged some basic tax principles. The ensuing uncertainties could over the long term place considerable strain on the tax system by increasing the opportunities for abuse and raising overall compliance costs. At the same time derivatives have provided a better understanding of the operation tax laws and from this standpoint have provided a positive input into policy design. This paper has three objectives: (a) to illustrate some of the weaknesses of the current tax system by focusing on several types of novel transaction; (b) to assess the validity of various types of adjustment proposed to tax code; (c) to draw out the implications of these developments for the ongoing debate over fundamental tax reforms and over source versus residence based taxes.