Tax Planning, Illiquidity, and Credit Risks: Evidence from DeFi Lending

This study establishes a plausible causal link between tax-planning-induced illiquidity and credit risks in lending markets. Exploiting an exogenous tax shock imposed by the Internal Revenue Service (IRS) on cryptocurrency gains, along with millions of transactions in retail-dominated Decentralized Finance (DeFi) lending, we document that tax-motivated borrowing strategies-intended to defer capital gains taxes-significantly reduce market liquidity, as borrowers become more reluctant to trade to avoid taxable events. This effect is particularly pronounced among individuals borrowing in stablecoins (a way to monetize returns), those with higher loan-to-value ratios (more risk-averse towards new regulations and typically with larger taxable gains), those with high returns in the underlying asset (repre-senting larger taxable gains), and those holding locked-in assets for over a year (i.e., converting high short-term to lower long-term capital gains tax rates). Using instrumental variable analysis, we demonstrate that tax-planning-induced illiq-uidity significantly increases the incidence of credit risks. A standard deviation increase in tax-induced illiquidity leads to a more than twofold increase in the value of defaulted loans. Our results remain robust across a battery of checks, including alternative model specifications and analyses of subsamples of highly tax-sensitive borrowers. Furthermore, they align with well-documented tax awareness periods, such as the year-end deferral effect. Overall, our insights are relevant to market participants, assist in estimating revenue losses for tax authorities, and inform emerging policies on the tax treatment of digital assets.