Corporate high flyers are in the President's sights, but one group is flying under the radar, writes Andrew Ross Sorkin.
AS THE White House and Congress wrangle over raising the debt ceiling and reducing the federal deficit, tax loopholes would seem to be an easy target for compromise. President Barack Obama has talked about eliminating breaks for partners at hedge funds and private equity firms along with corporate jet owners, oil companies and others taking advantage of quirks in the tax codes.
Here's another little-known group of tax code beneficiaries that he might want to add to the list: day traders and speculators who buy and sell futures contracts. For years, futures contracts, which are essentially bets on the price of commodities, stock indices and the like, have received a more favourable tax treatment than stocks. A trader who buys and sells an oil contract in less than a year even in a matter of minutes pays no more than a 23 per cent tax on the profits. Compare that with the bill for flipping shares of Google, General Electric or even a diversified mutual fund in the same time period. Those short-term investment gains are treated like ordinary income, meaning the rate can run as high as 35 per cent.
"There are so many ways to attack the logic of it," Warren Buffett, the chairman of Berkshire Hathaway, said in an interview about the futures tax break. "It doesn't make sense."
What does the tax loophole cost the government? Each year, the US gives up roughly $2 billion ($A1.88 billion) in lost revenue, according to the Congressional Research Service, a federal agency.
While that number may seem insignificant against the backdrop of the country's $US55 trillion debt load, tax inequities like this start to add up when considered collectively. Based on data from the Office of Management and Budget, the US could put another $20 billion in its coffers over 10 years if it taxed the investment gains of hedge funds and private equity executives as ordinary income. The so-called carried interest is treated like capital gains, which is taxed at a much lower rate.
Perhaps the tax break on futures contracts wouldn't be so irksome if it simply helped farmers protecting the value of their corn crops, airlines dealing with the rising cost of oil, or even individuals hedging the risks in their portfolio.
But the biggest beneficiaries seem to be day traders and speculators. Long-term investors account for only 20 per cent of the activity in the commodities futures market, according to a report by the Commodity Futures Trading Commission.
When I called Robert Green, a tax specialist whose clients include traders on the Chicago Mercantile Exchange, he acknowledged that it would be hard for Obama to justify lower tax rates "to benefit futures traders and commodities exchanges in his home state, while pushing hard to raise taxes on securities hedge fund managers often in Connecticut and New York City".
The genesis of the tax break goes back to 1981, when the government tried to close another tax loophole.
Some big investors were using the contracts to skirt taxes by creating a "straddle transaction", which allowed them to roll over their profits into the next year. So a rule was written that forced traders to mark their positions to market and pay taxes on unrealised gains.
In an effort to appease the investment community, a break was offered by Dan Rostenkowski, a Democrat from Chicago who was then the chairman of the House ways and means committee and later went to prison for corruption. In part, the break was meant to offset the risks associated with paying taxes on paper profits. He persuaded Congress that traders should pay a blended rate, paying 60 per cent of the long-term capital gains rate and 40 per cent of the ordinary income rate. Today, the combination amounts to about 23 per cent, assuming the top tax bracket for ordinary income is 35 per cent and the long-term capital gains rate is 15 per cent.
Eric Toder, an economist at the Tax Policy Centre, said the tax break might have made sense a generation ago when the market was mainly investors protecting their long-term profits. But with speculators betting on short-term price movements, the loophole is just that a loophole.
"It seemed like a reasonable compromise at the time to stop the straddle transactions," Toder said. "In retrospect, if the trading is so short-term, it seems a little silly to give them preferential treatment."
Frequently Asked Questions about this Article…
What is the futures tax loophole and why should everyday investors care?
The article describes a tax rule that gives traders who buy and sell futures contracts a more favourable tax treatment than short‑term stock traders. Because profits from many futures trades are taxed using a blended capital‑gains/ordinary‑income formula (about a 23% rate in the article’s example), day traders and speculators can pay less tax than someone flipping shares — which matters for fairness and government revenue.
How does the tax treatment of futures differ from taxes on short‑term stock trades?
Futures gains are taxed using a 60/40 blended formula (60% treated as long‑term capital gains, 40% as ordinary income), which the article says works out to roughly 23% assuming top ordinary rates. By contrast, short‑term gains on stocks are treated as ordinary income and can be taxed up to the top ordinary rate (about 35% in the article’s example).
Who are the main beneficiaries of the favourable tax treatment for futures?
Although futures were originally intended to help hedgers such as farmers and airlines, the article says the biggest beneficiaries today appear to be day traders and short‑term speculators. The Commodity Futures Trading Commission data cited indicates long‑term investors account for only about 20% of activity in the commodities futures market.
How much revenue does the futures tax break cost the U.S. government?
According to the Congressional Research Service cited in the article, the U.S. gives up roughly $2 billion a year in revenue because of the favourable tax treatment for futures traders. The piece also notes related tax preferences, like carried interest, would add more if changed (an estimated $20 billion over 10 years for carried interest in the article).
How did this blended tax rule for futures originate?
The article traces the rule back to 1981. Policymakers had tightened rules to stop investors using 'straddle' transactions to defer tax, but then offered a compromise — a blended rate (pushed by Rep. Dan Rostenkowski) to offset the risk of paying tax on paper profits. That compromise became the current preferential treatment for many futures trades.
Would changing the futures tax rules affect legitimate hedgers like farmers or airlines?
The article suggests the original justification for the break was to help legitimate hedgers protect against price risk. It notes that reformers would need to consider those uses — but that in practice the biggest users now are short‑term speculators rather than traditional hedgers.
What do experts and high‑profile investors say about this tax advantage?
The article quotes Warren Buffett calling the preferential treatment illogical — 'It doesn't make sense.' Economists like Eric Toder are cited saying the break may have been reasonable decades ago, but now looks like a loophole when much trading is short‑term. A tax specialist (Robert Green) also notes the political difficulty leaders face in changing rules that benefit traders in their own states.
Could Congress or the President close the futures loophole and how politically feasible is reform?
The article says tax loopholes are a logical target during debt and deficit talks and mentions President Obama discussing eliminating certain breaks for hedge fund and private equity partners. But it also highlights the political complexity: some breaks were created as compromises and changing them can be difficult because powerful interests benefit from the current rules.
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