Tax Gains from Derivatives as Ordinary Income on a Mark-to-Market Basis
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
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|Change in Revenues||0.6||3.9||3.3||1.8||1.6||1.6||1.5||1.5||1.4||1.4||11.2||18.7|
A derivative is a contract requiring one or more payments that are calculated by reference to the change in an observable variable (often, but not always, the value of an asset) after the contract is entered into. The simplest derivatives are contracts to exchange an asset—for example, equity stocks, commodities, or foreign currencies—at a future date and at a predetermined price. Such simple derivatives can be flexible contracts that are privately negotiated between parties, known as forwards, or standardized contracts that are actively traded on exchanges and are known as futures. There are also a variety of more complex derivatives, such as options and swaps. In an option, one party has the right to buy (or sell) the underlying asset at a predetermined price at any time before the contract expires. In a swap, the derivative is not tied to a specific asset; instead, it involves the exchange of cash flows that depend on uncertain variables, such as interest rates or exchange rates.
Derivatives are used for a variety of purposes, including hedging (insuring against changes in an asset price, foreign exchange rate, or interest rate) and speculating (betting on changes in an asset's price). Taxpayers can also use derivatives to lower their tax liability, because a derivative contract can delay the realization of gains from an investment—and, as a result, potentially reduce the tax rate applied to those gains—without altering the magnitude or riskiness of that investment.
There are two main dimensions along which the tax treatment of derivatives can vary. The first is the timing of recognition of gains and losses for tax purposes. For some derivatives, gains or losses are not recognized until the underlying asset changes hands or the contract expires or is sold. Other derivatives are taxed on a mark-to-market basis—that is, their gains and losses are calculated and taxed each year on the basis of the year-to-year change in the derivative's fair-market value. The second dimension is the categorization of income and losses. Income from some derivatives is categorized as ordinary income. Income from other derivatives is categorized as short-term capital gains, which are taxed at the same rates as ordinary income, or as long-term capital gains, which may be taxed at a lower rate. (See "Raise the Tax Rates on Long-Term Capital Gains and Qualified Dividends by 2 Percentage Points and Adjust Tax Brackets" for background on the taxation of capital gains.)
The tax treatment of derivatives along the two dimensions described above depends on several factors, including the type of derivative. Gains or losses arising from derivatives that are traded outside of exchanges generally are taxed when the contract is settled, has expired, or is sold. By contrast, derivative contracts that are actively traded on exchanges and have a clear value, such as futures, generally are taxed on a mark-to-market basis. The gains and losses from such derivatives are subject to a hybrid rate: 60 percent of the gain or loss is taxed at the rate applied to long-term capital gains and 40 percent is taxed at the rate applied to short-term capital gains.
Two derivatives that are otherwise identical may be taxed differently on the basis of characteristics of the people who hold them. For example, if a derivative is held by a dealer in securities—even if it is not traded on exchanges—then it generally must be taxed on a mark-to-market basis. The same derivative held by an individual investor may be subject to tax only when it is settled or expires.
Like the characteristics of the holder, the purpose for which a derivative is held can also change how it is taxed. As an example, if a derivative is used for hedging, then gains and losses arising from the derivative are taxed in the same way as the underlying income flow or asset. By contrast, gains and losses from derivatives used for speculation are often, though not always, treated as capital gains.
Taxpayers are required to report taxable gains from derivative contracts traded on organized exchanges to the Internal Revenue Service every year; however, they generally are not required to annually determine the market value of derivative contracts that are not traded on exchanges. For that reason, annual data on total taxable gains are not available. Because the value of derivatives depends on the business cycle, taxable gains are generally larger during periods of economic growth.
Under this option, most derivatives would be taxed on a mark-to-market basis. All holders of those contracts would be required to compute their gains or losses at the end of each year on the basis of changes in the contracts' fair-market value during the year. Those gains and losses would be taxed as ordinary income.(When the market value of a derivative could not be readily ascertained, taxpayers would be allowed to rely on its book value, as long as that value was estimated in accordance with accepted accounting standards.)
The option would exempt certain derivatives related to real estate and those used for hedging by businesses. In addition, the option would not extend to employee stock options, insurance contracts, or annuities.
Effects on the Budget
If implemented, this option would increase revenues by $19 billion from 2019 through 2028, the staff of the Joint Committee on Taxation estimates. That estimate incorporates expected reductions in the use of derivatives, which would occur because the option would increase the tax rate on gains from derivatives and would also make it significantly more difficult for taxpayers to use derivatives to lower the amount of taxes they owed.
The increase in revenues would be modest because under current tax law, at least one of the two parties in most derivative transactions is already taxed on a mark-to-market basis. Over the 2019-2028 period, the increase in revenues would be larger in earlier years because, on net, the mark-to-market regime would accelerate the taxation of gains. Initially, the revenue effect would be driven by that earlier taxation. In later years, the revenue effect would be smaller because gains that otherwise would have been taxed in those years had already been taxed in earlier years, which would offset the increase in revenues from the accelerated taxes.
The estimate for this option is uncertain because the current market value of derivatives that would be affected by the option is uncertain. Additionally, the Congressional Budget Office's projections of the economy, which affects the volume of derivatives, are uncertain. The market value of derivatives that are taxable in a given year largely depends on business-cycle fluctuations. The extent to which taxpayers would respond to this option by changing their reliance on derivatives for investing and managing risks is also uncertain. Few comparable tax changes have occurred in the past, so the empirical evidence on how people would respond to such a change is limited.
An argument in favor of this option is that it would eliminate a legal strategy that enables some taxpayers to reduce their taxes. Sophisticated taxpayers are able to use derivatives to lower their tax rate by advancing the recognition of losses but delaying the recognition of gains. Implementing a mark-to-market tax regime would reduce such opportunities for tax avoidance by giving taxpayers less control over the timing of gains and losses from the sales of their assets. The resulting increase in tax payments would be progressive, because the taxpayers who use derivative contracts to lower their tax liability tend to be wealthier and have higher incomes.
Another argument in favor of this option is that it would simplify the taxation of derivatives by applying the same tax treatment to most derivatives. In the case of derivatives that are difficult to value, it would make their tax treatment more consistent with their accounting treatment. However, the option could introduce new complexity into the tax system if extensive rulemaking was required to prevent opportunities for abuse in the valuation of such derivatives.
An argument against this option is that taxing unrealized capital gains on an asset before it is sold is onerous when the asset is not divisible or could not be readily sold on exchanges. By taxing derivatives on the basis of increases in their fair-market value before they are liquidated, this option would confront some taxpayers with an immediate tax liability even when they did not have the liquidity to meet it. An alternative approach would be to restrict the mark-to-market regime to derivatives that can be easily sold on exchanges. That approach would address taxpayers' concerns about liquidity but would also limit the advantages of the mark-to-market regime.
The option would reduce the use of derivatives for speculation by treating gains on those derivatives as ordinary income instead of capital gains. The overall effect of that reduction on financial markets is uncertain. On the one hand, speculation has a stabilizing effect on the financial system and the economy because it induces asset prices to move toward levels that reflect the true economic value of those assets. On the other hand, irrational or excessive speculation has a destabilizing effect on asset prices, the financial system, and the economy.