Risk Markets And Politics

Friday, April 21, 2006

Tax Futures

Readers will be unsurprised by this concept, as we've referred to markets linked to legislative outcomes somewhat frequently, especially tax and subsidy legislation. If such markets are to catch-on, it may be possible to hedge against future tax burdens. The $2 trillion tax cuts pushed through by the Bush administration are set to expire by 2011. Budget concerns and a somewhat-related defensive posture by Republicans make it increasingly unlikely that they will be extended. The CBO estimates that lengthening them through 2016 would reduce government revenues by $1.5 trillion. Could a market develop around these large risks?

Consider a set of 0-100 markets predicting the rates of the higher US (inflation-indexed) tax brackets in 2012: {27, 30, 35, 38.07}. Assume that no margin deposit is required or that deposits earn interest, so there is no material cost-of-carry. Since the current bracket rates are {25%, 28%, 33%, 35%} and, without extension, they will revert to {28%, 31%, 36%, 39.6%} in 2011, these prices can be seen as implying a 33% chance of extension.

Setting the markets up in this way avoids referring to any specific piece of legislation or policy. In practice, such markets might not refer directly to marginal bracket rates, but rather predict effective rates for income levels. It just seems more clear to present this example in terms of the bracket rates. Markets based on effective rates and income levels would have to take inflation into account, in which case the interpretation of prices would become more ambiguous. In any case, most of the trading will occur in the higher brackets or income levels.

Some of the earliest and most popular prediction markets (per se) have been linked to elections, but predicting tax rates is much more to-the-point in terms of financial risk-sharing. The existence of such markets would also frame the operation of the government in a way that would encourage fiscal responsibility, and give dispersed interests some recourse against inefficient spending.

At present, it seems that the US tax schedule will either shift upwards or remain the same, but such markets would also allow for pricing the chances of the slope, the progressivity, of the tax schedule changing. To complement the bracket rate markets, contracts could be established to cover the other cuts set to expire such as the estate tax (2011), capital gains/dividends (2009) and the marriage penalty (2009), or AMT-related changes — any piece of legislation that determines one's final tax liability. Markets could also be formed around corporate taxes or more general modifications in the tax code, and might ease the passage of sensible yet otherwise politically infeasible changes, as the interested groups could hedge with one another.

The problem is that in most scenarios, everyone is a natural buyer. Every tax-payer has exposure to higher tax rates, and this may severely limit trade.
The natural seller would be the government itself, but this is unlikely since it would probably lose in such markets at the most unfavorable times, as when taxes are raised to bring the deficit under control. Overseas speculators could account for some selling, as could domestic special interests that receive subsidies or industry-specific tax-breaks, suspecting that they might be lost if taxes are brought lower. Alas, the selling from these groups probably would not be very substantial. Contracts related to industry subsidies and tax-breaks would be more feasible in terms of market balance, but those might be better served by OTC arrangements.

In the coming weeks, we'll examine some notable past failed futures markets.

7 Comments:

  • "Consider a set of 0-100 markets predicting the rates of the higher US (inflation-indexed) tax brackets in 2012: {27, 30, 35, 38.07}. Assume that no margin deposit is required or that deposits earn interest, so there is no material cost-of-carry. Since the current bracket rates are {25%, 28%, 33%, 35%} and, without extension, they will revert to {28%, 31%, 36%, 39.6%} in 2011, these prices can be seen as implying a 33% chance of extension."
    Are you sure? I would say 66%

    By Anonymous jck, at 5:42 PM  

  • Extension of the tax cuts would retain the lower brackets, so the prices imply a 67% chance of no extension and 33% of extension. (e.g. 25*.33 + 28*.67 = 27)

    The prices could be ambiguous with respect to specific events though. The prices on the first three brackets here {27, 30, 35} could also imply no chance of extension, but a 50%/50% chance of the 2012 brackets being either {26%, 29%, 34%} or {28%, 31%, 36%}. This ambiguity has the advantage of not requiring the contracts to explicitly refer to any piece of legislation or policy.

    By Blogger Jason Ruspini, at 7:07 PM  

  • Agreed.I was being facetious,but if you want a market on "extension" or "no extension" a simple binary would do.
    The presence of a set creates ambiguity and I am not sure that's a good thing. Absent clear wording of the proposition,you can make up a probability to mean whatever you want,so there is no unique extraction of probability or unique tax brackets with your set,which I think ,defeats the purpose.There is no certainty that the 2012 brackets will be within the set or that there will 4 brackets for that matter...you could have a flat tax or no income tax at all [replace lost revenue with v.a.t],that's low probability to be sure but not zero.
    Perhaps something worth exploring would be something like the argentinian gdp-linked warrant except the base instead of gdp or excess gdp [growth above some predefined level]could be the total tax take or corporate tax take or whatever.

    By Anonymous jck, at 5:27 AM  

  • The motivation behind using brackets was to have general, longstanding and liquid markets for taxes. I tend to think that the ambiguity of their prices is a lesser evil than the contractibility and liquidity problems of contracts referring to specific legislation and policy. Of course, as you point-out, any number of developments could disrupt the usefulness of bracket markets. A couple thoughts on that: 1) It might help to use effective rate/income level markets, or side-markets attached to AMT changes etc, both as i suggested. 2) If policy-makers are dead-set against the existence of such markets, all of this is a moot point. If not, is it an unreasonable assumption that they would respect their functioning and be wary of jarring them unnecessarily? In any case, new markets could be formed to handle more general changes to the tax code, and this process should be at least as nimble as the machinations of (non-hostile) legislators. These new markets could feed-off the liquidity of the older, established tax rate markets.

    Yes, markets linked to tax-receipts would be worth exploring. A conditional market projecting receipts based on rates comes to mind.. interesting.

    Thanks for your great commentary jck, as usual

    By Blogger Jason Ruspini, at 8:15 PM  

  • Over the years buyers of dividend or capital gains tax futures would have would have been big time losers so there might well be two sides to this market.

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