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By Elliot Turner

Oil explodes higher then plummets back to Earth.

(Click to enlarge)

Ever since attending Revenue Watch’s Boom, Bust and Better Policy (see my review) I have been trying to delve deeper into some of the themes discussed by the panel.

The panel focused on how to design policies such that resource rich developing nations can limit the consequences of increased volatility in the price of the commodities they own. Heightened volatility leads to increased uncertainty when budgeting, and this uncertainty generates serious risks in its own right. While the panel focused primarily on how countries can deal with this volatility, I wanted to take a closer look into WHY commodity prices are so inherently volatile to begin with these days.

I believe we are in a state of heightened global macroeconomic volatility, and that does yield way to increased volatility in demand and pricing for resources; however, that alone does not explain some of the radical swings in commodities ranging from oil to palladium to gold of late. In looking at the tax code’s treatment of commodity speculation relative to equity speculation we have one possible clue.

Tax Code Structure for Speculation

Since the 2003 Tax Cuts, long-term capital gains are taxed at a 15 percent rate, while short-term capital gains are taxed as general income, at a 35% rate. These capital gains apply on most forms of investment income; however, they do not apply on gains in futures contract transactions – the principle way in which commodities are traded. Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60 percent long-term capital gains and 40 percent short-term. The blended rate results in a 23% tax on gains in futures/commodity trading (check out this site for more information on trading taxes).

In essence, for the short-term speculator, the tax code incentivizes participation in commodities markets, as opposed to equities. Short-term traders tend to be speculators and/or liquidity providers, not long-term investors. Whereas short-term equity speculation is taxed at a 35% rate (general income), commodities/futures speculation is taxed at 23%. Is there such a need for the tax code to set a liquidity preference for commodity markets as opposed to equities? I surely do not see any reason for this.

In order to profit, short-term transactions require inefficiencies (or a spread) between buyer and sellers PLUS volatility in order to generate a profit. As spreads in our financial markets have gotten smaller, the short-term speculator increasingly relies on heightened volatility to generate a profit. This is where the situations gets a little worrisome. In steering such traders to commodity markets, our tax code essentially subsidizes and incentivizes volatile fluctuations in these very important markets. Moreover, volatility becomes a self-fulfilling prophecy, because in seeking volatility, short-term transactions tend to exacerbate volatility.

Commodity Markets and Why Too Much Speculation Is Undesirable

The goal of commodity futures markets is to provide a venue through which buyers and sellers can share some of the risks in price fluctuations for important input goods and both can secure some sort of certainty for budgetary purposes moving forward. Short-term transactions that result in gains in commodity markets are not done with the intention of securing a buyer or supplier of input goods. They are in some ways tangential to the goal of commodity markets themselves. Rather, these transactions are done for the purpose of realizing a gain off of an actual change in price.

The Commodity Exchange Act recognized the troubling nature of speculation and its “burden on interstate commerce.” In the Act, Section 6(a) acknowledges the problem of “excessive speculation” and grants powers to regulators to help mitigate some of its negative consequences:

Excessive speculation in any commodity under contracts of sale of such commodity for future delivery made on or subject to the rules of contract markets or derivatives transaction execution facilities, or on electronic trading facilities with respect to a significant price discovery contract causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity [emphasis added].

Traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities. But, there is no reason for the government to provide an implicit subsidy in inducing speculators to prefer commodity rather than equity markets. Increasing numbers of speculators lead to wilder fluctuations in price and a create a marketplace in which a large quantity of the participants goals’ run counter to the purpose and intention of commodity markets. Moreover, the ripple effects from commodity volatility, as recognized by the Commodity Exchange Act, place “an undue and unnecessary burden on interstate commerce.”

When Congress revisits the tax code, it needs to focus beyond just the setting of rates. Congress must also focus on tax code structure. There is no need for subsidized commodity speculation. We cannot forget that before Lehman went bust, oil went buck-wild and created a shock which hurt a vast array of global businesses. At the moment, the commodity price shock seems to be a distant memory. It’s about time we take some action to prevent such a disaster from happening again.

Disclosure: No position