Camp’s Investment Tax Plan: Implications for Lower Rates on Capital Gains?

By :: January 30th, 2013

House Ways and Means Committee Chairman Dave Camp (R-MI) has proposed requiring most derivatives investors to pay tax on their annual returns even if they don’t realize their gains by selling their securities. This proposal, which requires investors to mark-to-market the value of financial derivatives, has ramifications far beyond the heady world of high-tech finance. It implicitly challenges our most basic and firmly held beliefs about why we tax investment gains the way we do.

Camp’s plan raises two key questions: First, should mark-to-market be required for all investment assets, not just derivatives? Second, does his proposal fracture one of the main justifications for taxing long term capital gains at roughly half the rate on ordinary income?

Ask most tax experts why, in a nutshell, rates should be lower for capital gains, and you’re liable to get a mini-lesson on the “lock-in effect.” There’ll be other reasons too. But the lock-in effect is going to be pulling some serious weight.

What the lock-in effect is and how it relates to mark-to-market—and why Camp’s proposal calls it into serious question—is best explained by way of analogy.

Imagine you’re a law professor, and your student comes to you with a note from the Dean saying that he should be allowed to take as much time as he needs on your upcoming exam. You shake your head, but decide it’s not worth bothering the Dean. The next day the student returns to your office to argue that his exam should also be graded more leniently. After all, given that he has as long as he likes on the exam, he’ll be temped to work on it an inordinate amount of time to the detriment of his other classes—unless, that is, he knows that he’ll get a decent grade in any event.

You’re astounded by the student’s audacity. Think of it: arguing that one problematic advantage, dubiously secured, deserves another. Rather than agreeing to grade more leniently, you resolve to call the Dean to question why the student is getting extra time in the first place.  (And you make a note to hire the student should you ever need legal help.)

The “lock-in” argument has the same basic structure as the student’s argument for lenient grading.

Start with the fact that investors “get as much time as they need” to pay tax on their accrued gains. Investment gains are taxed, not as they accrue, but only when they are “realized”—by, for example, selling the asset. This is a tax advantage because the unpaid tax stays on the taxpayer’s balance sheet and continues to earn income.

The lock-in argument then comes back for more: given that gains aren’t taxed until realized, it says, realized gains should be taxed at lower rates. Because investors can delay the tax until they sell the asset, they’ll be tempted to delay selling for an inordinate amount of time. That’s inefficient because better investments might crop up in the meantime. Keeping rates low reduces this tax-borne inertia.

Might it not be time to “call the Dean” about taxing only upon realization? Camp’s proposal—though it applies only to derivatives—is a strong prod to pick up the phone.

Proponents of the lock-in argument offer two main reasons to take the realization advantage as given. Camp’s proposal implicitly challenges both.

First, they say it’s just too hard to determine the market value of investments at year-end. That argument has always been suspect when it comes to publicly-traded securities for which prices are readily available with the click of a mouse.

But Camp now calls for marking to market derivatives whose underlying asset values are neither widely published nor even publicly traded. A derivative is merely a financial instrument, like an option or forward contract, whose value is tied to some underlying asset. One has to wonder: If it’s feasible to value the derivative, how can it not be feasible to value the underlying asset to which the derivative’s price is linked?

Second, proponents of the lock-in argument raise the specter of inconsistent treatment across assets. Sure, they say, some assets, like publicly traded stock, are easily valued and can be precisely marked-to-market. But others, like uniquely situated land, cannot be. Won’t that distort investment decisions and open up tax arbitrage opportunities?

In the context of a tax code full of partway measures, this too has always been a dubious argument. But it is even more suspect in light of Camp’s proposal.

He’d mark-to-market most derivatives but none of the assets from which they are derived. If disparate tax treatment distorts investment decisions between land and stock, would it not distort investment decisions between derivatives and their underlying assets? If tax arbitrage is a danger between stock and land, surely it is a danger between a derivative and its underlying assets. The arbitrage seems readymade.

Camp’s proposal is more than food for thought regarding derivatives. It’s a four-course meal for fundamentally rethinking how we tax investment gains.

6Comments

  1. Michael Bindner  ::  6:45 pm on January 30th, 2013:

    If the derivative results in some kind of income, it should be taxable. If it does not, however, I am not sure how it can be taxed constitutionally. Please explain further.

  2. Vivian Darkbloom  ::  5:07 am on January 31st, 2013:

    That would indeed be an interesting discussion, Michael, and this is perhaps one of the most sensible things you’ve written, even though in the end you’re likely wrong for reasons other than the one you may have in mind.

    While it has been about 93 years since Eisner v. McComber and the rationale of that case has been substantially modified in the interim, the requirement that income be “realized” in one sense or the other in order to be taxed is certainly not dead.

    Actually, the realization issue was at the fore when section 1256 was introduced to counter the abuse of straddles to convert ordinary income (short-term gains) to long-term capital gain income when the rate differential was 70 percent versus 28 percent (Professor Sanchirico, your’re either late for dinner or very, very early). Section 1256 already taxes “section 1256 contracts” on a mark-to-market basis and that solution was brought about because it was thought to be more administratively efficient than a “balanced position rule” that would require netting offsetting positions. Besides, (non-corporate) traders liked it because they got long-term capital gain treatment for 60 percent of the mark-to-market gain.

    Drafters were indeed concerned about the Constitution and the Eisner decision at that time and they set the JCT to work to find a proper justification. The original justification was that under the mark-to-market margining system utilized by exchanges, cash actually does (or could) change hands on a daily basis under the margining rules and this is the key to the constitutional issue. In fact, when the recent Dodd/Frank bill modified the rules with respect to certain OTC derivatives to bring them more in line with the non-tax rules applicable to exchange traded derivatives, a special tax provision was inserted in order to confirm that these contracts would *not* be subject to section 1256 as a result.

    Section 1256 was actually challenged once on constitutional grounds by a trader called Murphy. But, in Murphy v. United States, 992 Fed 929 (9th Cir 1993), the court upheld the law against the challenge, arguing that Murphy got constructive receipt due to the exchange margining rules, just as the JCT had prophesized.

    Depending on the specific details of any proposed change to section 1256, it could be subject to constitutional challenge. However, this challenge can easily be overcome if the regulatory rules are changed so that trading in the contracts meets the existing section 1256 standard. In fact, were it not for the tax carve-out in Dodd Frank, which would presumably now be undone, it appears that that bill has largely accomplished the necessary *regulatory work*. Camp need not throw out the “realization requirement”—at most he would need to change some regulatory rules in order to comply with it.

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  5. Chris Sanchirico  ::  3:34 pm on February 1st, 2013:

    William McBride of the Tax Foundation comments unfavorably on this post at the Tax Foundation website. (I could not find a way to respond there, so I will do so here.) The only point in his brief post is that there are other justifications–besides “lock-in”–for keeping capital gains rates low (as I note in the post itself). Putting aside whether and to what extent those other justifications hold water, I wonder about “the dog that did not bark” in Mr. McBride’s post. Is he conceding the “lock in” argument?

  6. WhiteyC  ::  7:43 pm on February 2nd, 2013:

    A discussion of marking gains to market is incomplete without a parallel discussion of losses.
    Does your suggestion include allowing taxpayers to mark losses to market, thus reducing ordinary income? If not, why not?
    This seems to me to be required by basic fairness if you mark gains to market.
    These losses are real cash losses just as much as the gains are real gains.