Risk Markets And Politics

Wednesday, February 06, 2008

Tax Futures, "In Real Life"

I am very pleased to announce the world's first explicit tax futures on Intrade. I thank John Delaney and everyone there for their help and enthusiasm in getting these off the ground.

The contracts will forecast the highest marginal single-filer federal tax rates for 2009, 2010 & 2011. I expect trade to be concentrated in the 2011 contracts, as Bush's 2001 tax cuts are scheduled to expire that year, reverting the rate in question from 35% to 39.6%, while the lower bracket rates each increase by 3%. While it is less likely, Congress may also alter the Bush tax cuts for tax years before 2011, but such changes would probably impact 2011 as well.

If reasonable liquidity can be sustained in these markets, I hope that contracts will be added to predict corporate taxes, and other factors that contribute to individual effective tax rates, like the Alternative Minimum Tax and the social security cap. Given the tremendous hedging utility of such markets, maintaining a liquid two-way market might be tricky, although there are some obvious ways for any market-makers to hedge what might become a position more short of taxes than usual.

Please read the last post on "Policy Event Derivatives" below for some background on the potential benefits of such markets. I should add that while I am confident in their long-term value of making better group decisions and sharing risk, I am sensitive to some foreseeable pathologies, and don't want to give the impression of being too cavalier at this point. There are potential problems and side-effects stemming from the use of such markets that will be addressed later.


  • Congress is increasingly creative at adding rate bubbles to phase out benefits. The stimulus package just added another 5% bubble starting at $75k/$150k. Other bubbles are 5% for personal exemption phaseout, approximately 1% for itemized deduction phaseout, 5% for child credit phaseout, and education credit phaseouts galore. Then there is the 35% marginal rate of the alternative minimum tax up to about $400k income as the AMT exemption is phased out. For all these reasons, the Schedule X statutory marginal income tax rates typically fall short of the actual (effective) marginal tax rates.

    This intentional obfuscation of effective tax rates by Congress is a huge challenge to the construction of useful Tax Futures contracts. There is no good alternative to a contract based purely on the statutory rate, but such a contract is a very imperfect hedge when the effective rate is often much higher than the statutory rate, and unpredicatably so.

    The statutory rate contracts provide a partial picture of our tax future, but they probably have more value as entertainment or forecasting than as a hedge.

    By Anonymous Anonymous, at 12:37 PM  

  • But no one trading the contract cares about effective tax rates; the contract is about nominal ones.

    If you make just over the minimum to reach the 35/39.6% bracket, your effective tax rate is significantly lower than your marginal one.

    Trading effective tax rates would give away the game on squealing about how high marginal ones are.

    By Blogger Ken Houghton, at 9:58 AM  

  • AMT, I addressed those contractability questions on my recent BNN appearance. No time to link now, but the basic idea is that we will spin-off markets if it looks like the current contracts are rendered ineffective.

    Ken, I am not really sure what your point is. Ultimately we care about effective rates, but contracts on marginal rates are the first building block to be able to the former.

    By Blogger Jason Ruspini, at 11:05 AM  

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