Columnist Andrew Ross Sorkin wrote a column about taxes. Specifically, Obama wants to raise taxes on hedge funds, private equity and venture capital. In the article, he also pointed out that futures traders get a big tax break, and maybe that loophole should be plugged.
Respectfully Mr. Sorkin, I disagree. Sure, I am biased. Obviously as a futures trader I don’t want taxes to go up. But there is a reason why we are taxed the way we are taxed and it’s not just because of the political deal you allude to in your post.
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 percent of the long-term capital gains rate and 40 percent of the ordinary income rate. Today, the combination amounts to about 23 percent, assuming the top tax bracket for ordinary income is 35 percent and the long-term capital gains rate is 15 percent.
Let’s take the VC/PE/Hedge Fund community first. If the Feds want to tax them at the highest rate on the salary they take from the money they raise, fine by me. How does that work, and why would I favor that?
Let’s say you set your fund up and it’s a 2.5%/20 fund. This means that you will collect a salary of 2.5% of the value of the fund, the money raised, and you will collect 20% of the growth of the fund if it’s successful. If it’s unsuccessful you get nothing. Assume a ten million dollar fund just for fun. As you know, sometimes these funds are in the billions. The manager of a ten million dollar fund will make the magical amount of $250,000/yr. That money ought to be taxed at the highest rate because they is guaranteed that salary. There isn’t any risk once the money is raised.
An aside, it’s not easy to raise money. Not just every Tom, Dick, or Harriet can raise a fund.
On the 20% gains any manager ought to pay only 15%, or whatever the capital gains rate is. Why? Because the fund manager is using his talent to take a measured risk. Not all these deals work out, not every trade a hedge fund makes works out. Hyde Park Angels, my angel group in Chicago, did some research and found out some of the best funds make all their money on two deals. The rest of the deals they invest in go broke.
Wall Street and Greenwich ($BX, $BEN) are littered with the remains of busted hedge funds, and fund of funds. Silicon Valley and Boston have had plenty of Venture Capitalists go belly up. Leverage buyout ($KKR) and Private Equity firms go out of business too.
If America wants venture capital, and other risk loving funds out there, then they can’t overtax them. They provide much needed growth capital to really big businesses. The backbone of the internet you are reading this blog on was financed by some risk loving venture capitalists. So was most of the software you use. Tax risk capital at a high rate, you will have less of it. It means less growth, lower GDP, higher unemployment.
Now let’s turn our focus to futures($CME, $ICE). Futures are extremely risky to trade. They are traded on margin and margin makes them whippier. The reason they exist is to allow producers and consumers to hedge risk. Risk is transferred. A speculator sometimes steps in the middle and assumes the risk. They might make or lose money, and if they make money, it means they took the correct calculated risk and were paid for it.
This transfer and assumption of risk smooths out prices for everyone. It makes goods and services cheaper to the public. Here is an oft cited example, onions and crude oil. Which one has futures, and which doesn’t? Which one has a more stable price?
Each futures contract is “marked to market” every day. Money is taken out of, or put in trading accounts depending on the settlement price. They are transparent. On the last trading day of the year, all profits and losses must be realized and paid for, including all the federal and state taxes owed-and this is a critical point-even if you haven’t closed the position.
In the stock market, you are not taxed until you sell your stock. You don’t pay a tax on your gain every December 31st.
Here is how it worked for me between 2008 and 2009. True story. I was trading pretty big and in August of 2008, I began to get short the hog ($HE_F) market. I wound up naked short a boatload of hog contracts. In dollar terms it was $4 per tick times the number of contracts I held per tick. I had more than 100 shorts on, not too mention all the spreads I held. The hog market generally moves between 50-120 ticks per day. That meant I was losing or making a significant amount per day on my position. To hold that position, I had to commit risk capital in margin each and every day. The larger the position, the more the margin. Typical margin rates at the time were around $370 per contract, so I needed to keep a very large amount of money in my account at any one time. But, my clearing firm wanted significantly more than that since a large move could potentially wipe out my account. That also meant I couldn’t use that money for anything else. My wife wasn’t running to Hermes to buy a Birkin.
I held the position through the ups and the downs of September, losing or making significant amounts of money each day. The financial crisis hit in October, and the bottom fell out of every commodity market. I had a huge winner.
I rode it, never getting out until December 31. Recall the “mark to market” pay the tax man on December 31st rule. I let the futures ride over the year from 2008 to 2009, paying a 23% tax on the gain.
On the first trading day of 2009, the market was limit up, 300 points. It went higher on the second day, around 120 points. I lost $1680 per contract, and I had already paid taxes on them. Uncle Sam got his, and I was losing my ass.
Eventually, the market turned around and then swine flu hit. So, I made all my money back plus a little more. Mrs. Carter still didn’t get her Birkin, but we had some money in the bank.
That’s why futures are taxed the way they are. The tax rate recognizes the risk and function of the marketplace.
Now, if the Feds and people like Mr. Sorkin would like to go back to the old way of taxing futures pre 1981, I would be happy to do so. In those days futures traders were able to put on a tax straddle. You would put a spread on during the last week of December and manipulate the market so you would lose the entire years gain. Then, when January hit you would take the spread off and get all your money back-paying 0% tax on gains. Roll it over year after year and then pay taxes on whatever you couldn’t hide when you retired.
The solution of 60/40 tax (cap gains/top rate) wasn’t a political deal as Mr. Sorkin insinuates. It was a good resolution on how to best tax futures markets with a nod to the recognition of risk in trading, keeping and assisting the beneficial transfer of risk around the marketplace, and getting futures traders to pay something. Otherwise the government received relatively little tax because everyone could avoid it.
The government should tax business activity based on the benefit to the economy, and the risk taken to derive that benefit. A salaried worker should pay more in tax than a straight commission employee. If they want to make it simple, just tax everyone a flat tax at 15%, no write offs.
This is the kind of faulty logic is that happens when you tax futures like stocks. They aren’t the same animal. That’s also what happens when you regulate futures like stocks, but that is another post for another day.
Now, see the sort of debate we are engaging in? It’s about government picking winners and losers via tax code. Futures traders have too much etc.
This is precisely why I advocate for a flat tax with no write offs and ending subsidies. No picking. Everyone meets the same standard and we compete. Don’t worry, government revenue will increase. There will be more economic activity to pay for everything.
Do not believe the Democrats that say revenue won’t go up. They are using accounting logic, not economic logic. All they want is more control over your life. Economic Freedom=Individual Freedom.
Thanks for the link, Abnormal Returns