Tax Arbitrage Feedback Theory

A new angle for understanding the global credit crisis of 2008-2009 is presented. Based on control theory principles and the axiom that investors seek the highest, expected after-tax return, I develop
the Tax Arbitrage Feedback Theory. TAFT explains how the subtle effects of differential tax rates
for various market participants produce incentives that strongly contribute to instability and
boom/bust economic activity. Moreover, TAFT explains how observed bond credit spreads should
be impacted by differential tax rates, in addition to the conventional bankruptcy and recovery
factors. The purpose of debt securitization products, when viewed through a TAFT lens, is not only
diversification and partitioning of risk, but also tax minimization. Credit default swaps are revealed
to be a massive tax arbitrage that shifted government tax receipts to Wall Street bonus pools and
necessitated the creation of massive quantities of low credit quality debt.