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PREDICTION MARKETS IN TAX RATES

February 11, 2008

Prediction markets are increasing in popularity. The idea is simple: allow people to place bets on the outcome of future events. Sports betting is the oldest such market, but the Iowa Electronic Market extended the concept to politics. Now an electronic market has opened to allow bets on future tax rates:

The contracts will forecast the highest marginal single-filer federal tax rates for 2009, 2010 & 2011. I expect trade to be concentrated in the 2011 contracts, as Bush's 2001 tax cuts are scheduled to expire that year, reverting the rate in question from 35% to 39.6%, while the lower bracket rates each increase by 3%. While it is less likely, Congress may also alter the Bush tax cuts for tax years before 2011, but such changes would probably impact 2011 as well.
If reasonable liquidity can be sustained in these markets, I hope that contracts will be added to predict corporate taxes, and other factors that contribute to individual effective tax rates, like the Alternative Minimum Tax and the social security cap.

If these take off, the obvious application is to hedge your decision to go with after-tax contributions to a Roth IRA or Roth 401(k). Such contributions aren't deductible now, but they can be withdrawn on retirement, along with their earnings, tax-free. Making a Roth-type contribution is partially a bet that your tax rates on retirement will be high enough that it's worth foregoing a current deduction. A futures market might enable you to reduce the risk of a wrong bet by buying a contract betting that rates won't go up.

It's a complex bet. I think the growth of government may put irresistable pressure on rates, but I also think that there is a lot of base-broadening that can be done that could enable rates to go down. The bet has to take into account who will win the White House and Congress, and whether they mean what they say. It should be fun to follow. You can follow these contracts here.

Intrade tax rate markets as of 9:05 central time 2/22/08