Gregory Besiger of the New York Post reports on House Ways and Committee Chairman Dave Camp’s efforts to reform the taxation of financial instruments, and how they’ve sparked intense resistance from the financial services industry. Though I don’t agree with all of Camp’s tax reform priorities — though I’m sympathetic to a broader base and lower rates, I’d prioritize a more generous child credit over substantially lower rates and it seems fairly clear that he does not agree — my strong impression is that he is in the right. Floyd Norris of the New York Times has explained Camp’s approach in broad outline, as has Richard Rubin of Bloomberg. Victor Fleischer of the University of Colorado Law School, writing in Dealbook, is a fan of the proposal:
The building blocks of our current tax system were laid down in 1954, long before derivatives were commonplace. Mr. Camp’s proposal would shift the taxation of financial instruments like options, swaps and futures from our current realization-based system to a mark-to-market system.
Suppose for example that you approach an investment bank to purchase an option to acquire 1,000 shares of Facebook at $30 a share, just above today’s market price. Assume the option is long-dated and expires in five years. By the end of the first year, assume the value of Facebook has increased to $40 a share.
Under current law, the option contract is treated as an open transaction, and the option holder would not pay tax on the appreciation in value until the option is sold or, if exercised, until the underlying Facebook stock is sold.
But Mr. Camp’s proposal would require the option to be valued at the end of each year based on what the profit would be had the option been sold and repurchased it at the end of each year. If the option declined in value, you would have the benefit of a tax loss.
Wall Street has responded cautiously to the proposal. A change in the law would not necessarily hurt Wall Street directly. Most financial instruments held by investment banks and some other financial institutions are already taxed on a mark-to-market basis because the banks are treated as dealers, not investors, under section 475 of the tax code.
The proposal would instead probably hurt individuals who enter into bespoke financial contracts with banks in order to avoid tax. The change thus might hurt Wall Street indirectly by reducing demand for such contracts.
But cleaning up the taxation of derivatives would also benefit Wall Street by making it easier for companies with business reasons to hedge risks to do so without facing tax uncertainty. (Legitimate business hedging would be carved out of the new mark-to-market system.)
The hope is that Camp’s reform will help make the financial system more transparent and stable, and that it will reduce the amount of time and energy firms devote to tax arbitrage. Camp’s work on this front is very encouraging — it is frankly some of the only encouraging news coming from Congress, with the possible exception of House Majority Leader Eric Cantor’s Making Life Work agenda and Utah Sen. Mike Lee’s emergence as a policy thought leader. I discussed Camp’s derivate taxation reform proposals in greater detail a few months back, but unfortunately we’re having some trouble with our archives. A GOP-aligned Wall Street lobbyist appears to have convinced some reporters that Camp’s tax reform efforts reflected a desire to punish corporate CEOs who had called for tax increases during the debt ceiling debate, but of course his reform would tend to benefit the kind of non-financial firms that joined the Fix the Debt coalition.