Pearls of Wisdom: Replacing One Loophole with Another

First, some background. What is a “Futures Contract”? Basically, it is a contract that ensures you will buy or sell something in the future, for a price that is specified in the contract. I will explain (briefly) the historical development, in order for you to see the context of the current market.

Say there is a farmer growing wheat in Nebraska. One of his challenges is that he doesn’t know that the price of wheat will be when he sells it. He doesn’t know exactly when it will be ready to harvest. Wheat also has the problem that it is inconvenient to store, so the farmer could be disadvantaged if he harvests all the wheat, and potential buyers know that he wants to sell it immediately and will take whatever he can get.

In the early days of our nation, a custom of farmers selling their crops before harvesting them started. That worked well, but had some problems:

  • Credit risk. If the weather was good, and there was a good harvest, that would cause the price of the crops to decline. The farmer was dependent on the buyer to pay the agreed upon price even though the current price is lower. That situation led to both inability to pay, and all kinds of disputes about the quality of the product, etc.
  • The buyer also had a similar risk of the farmer failing to deliver.
  • The wheat from one particular farmer has to be transported to that one particular user. This is potentially wasteful as there could be other farmers much closer to the particular buyer, and other users much closer to the particular farmer, but who were not buying at the exact moment when the farmer decided to sell.

Eventually, a new system was developed. They created an institution, called the Chicago Board of Trade. Representatives of buyers and sellers would get together there, to buy and sell the future crops in an open auction system, very much like the stock exchange. The way the CBOT worked is that after the trade is agreed upon, the institution becomes the counterparty for both sides. That means that the farmer had an obligation to deliver wheat to the CBOT in exchange for money, and the buyer had an obligation to deliver money in exchange for wheat. Neither had any concern about specifically who the counterparty is on their trade. The CBOT had all kinds of rules about when and how delivery was to be made (on rail cars, at a certain time and place, ec.) as well as requirements for the parties to make deposits (called “margin”), etc.

Just before delivery time, the price of the contract is the same as the price of wheat (because one can be converted to the other). Prior to that, the price of the contract can vary based on expectations of the future price of wheat, interest rates, storage costs, and other factors.

Generally, most people liquidate their contracts prior to the delivery time. If, for example, the price of wheat drops from five dollars to four dollars per bushel between the time the farmer sold the wheat and the delivery time, the farmer would usually sell the contract (getting a profit of one dollar per bushel of wheat) and then sell the wheat to whatever convenient local buyer he has for four dollars per bushel. His total proceeds are the five dollars per bushel for which he initially sold the wheat. Because he can deliver the wheat on the contract if he wants to, he is assured of getting the agreed upon price.

This actually worked (and still works) pretty well. Part of the reason it works well is that the market in wheat futures (and all of this applies to many other things besides wheat) is very liquid. “Liquid” means that pretty much any time during business hours someone can buy or sell a wheat contract and get a fair price. That is because there are a lot of people (speculators or traders) who buy and sell what futures all the time. The total volume of trading is significantly larger than the actual amount sold by farmers. That is a good thing. That prices are reasonably stable, going up and down based on fundamentals like the weather and population growth, but not very much because some farmer does or does not decide to sell on a particular day.

Then, in the early 1980s, wealthy Americans started using futures contracts as tax shelters. The basic idea was like this. Let’s say you’re having a good year in 2017, and you’re planning to earn a high salary, say one million dollars. In March, you enter into two futures contracts.  One to sell ten million dollars worth of wheat in the fall of 2018, and one to buy ten million dollars worth of wheat in the fall of 2018. The contracts will have two different delivery dates. The two will move together (they are the same contract) but wheat goes up and down. In late 2017, one will be up and the other will be down by the same amount. You then liquidate whichever one is a loss in late 2017, and enter into another contract with the same delivery date as the profitable contract you are keeping. The entire position would be liquidated in 2018 (before the delivery date).

The result of all of this would be having a significant loss in 2017, and a long term capital gain of the same amount in 2018. That means a big tax deduction in 2017, and a much lower tax liability in 2018 (because it would be a long term capital gain).

Congress saw this as a problem. They passed a new rule so that at the end of each year, everyone has to pay tax on any profit from any futures contracts whether they sell them or not, and all such profits will be taxed at 60% at the long term preferential rates and 40% at the short term earned income rates (regardless of how long the taxpayer has owned the contract). This did remove some of the gaming and tax sheltering that people used to do. But it also replaced one loophole with another.

The result, though, is that people who trade futures contract (which does nothing to generate jobs, etc. except for people in the trading business) pay 60% of their income taxes at rates far below the rates paid by ordinary working Americans – at capital gains rates. This has done nothing to rebalance a system that favors the few over the many, and is not fair to ordinary citizens who are paying higher tax rates simply because they have a different job.

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