Home > Economics, Finance, Politics > Tax Code and Commodity Volatility

Tax Code and Commodity Volatility

Ever since attending Revenue Watch’s Boom, Bust and Better Policy… (click here for my review of the panel) 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 increase volatility in the price of the commodities they own.  Heightened volatility leads to increased uncertainty when budgeting in resource rich countries, and this uncertainty comes with serious risks.  While the panel focuses primarily on how countries can deal with this volatility, I wanted to take a closer look into WHY commodity prices are so volatile.

I believe we are in a state of heightened global macroeconomic volatility, and that alone 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.  With today being April 15th–the ever-dreaded tax day–it seems only natural to discuss the tax code and the role that it plays in resource volatility.  Since the 2003 Bush 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 contracts–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, the tax code promotes short-term speculation in commodities markets.  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, a commodities/futures speculation is taxed at 23%.  Is there such a significant need for liquidity in commodity markets such that we want to incentive speculation there as opposed to equities?  I surely do not see any reason for this.

The goal of commodity futures markets is to provide a venue through which sellers and buyers can share some of the risks in price fluctuations and both can secure some sort of certainty for budgetary purposes.  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.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide an implicit subsidy in inducing speculators to prefer commodity rather than equity markets.

Increased prevalence of speculators lead to wilder fluctuations in price and a greater quantity of participants whose goals run counter to the purpose and goal of commodity markets.  Hopefully when President Obama and Congress revisit the tax code as the Bush tax cuts expire, they will look further into subsidized commodity speculation.  This is a topic I will continue to explore further and something which I believe requires more press and attention as we try and assess the damage done by the financial crisis and forge ahead with a revised framework for our financial and economic systems.  We cannot forget that before Lehman went bust, oil went buck-wild and created a shock which hurt a vast array of global businesses.

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  1. April 15, 2010 at 7:52 pm

    This taxation change coupled with a reduction in leverage would seemingly go a long way in reducing commodity market volatility.

    http://www.twsinvestments.com/2009/07/reduce-leverage-in-oil.html

    • April 16, 2010 at 5:33 pm

      Agree completely Brandon! Leverage is a dangerous tool when the goal is providing suppliers and consumers with earnings and cost certainty.

  2. April 28, 2010 at 9:17 pm

    yo wat is ur MySpace name?

    • April 29, 2010 at 10:22 am

      Not on MySpace but you can find me on Facebook…

  1. April 15, 2010 at 5:43 pm
  2. April 15, 2010 at 11:09 pm
  3. April 15, 2010 at 11:48 pm

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