Friday, October 31, 2008

Tax Futures: Cutting to the Chase

For most people the election outcome will manifest itself most directly in the form of taxes. We can easily ascertain the general platforms of each candidate on this issue, but the specifics are intentionally left a little vague during the campaign season. Since they launched in February, the Intrade tax contracts help to cut through candidates' omissions, and provide a direct hedge to this pervasive risk. It's good to know who will win the election, but it's better to know how the result will affect you -- and be able to do something about it.

The tax contracts can be interpreted as revealing the probabilities of tax changes conditional on who wins the election. For example, currently they give a 61% chance of the top marginal rate for single filers going up in 2009. If we assume this would be impossible under McCain's veto power, since Obama's chances for the presidency are 84%, this implies a 73% percent chance of taxes being raised in 2009 if Obama wins. That is, P(tax hike GIVEN Obama win) = P(take hike AND Obama win) / P(Obama win). Once the election is over, the contracts will continue to reflect the likelihood of legislation passing and other fiscal developments that might spur policy.

Of course, these specific markets are still young enough that marginal buyers and sellers can have a significant influence on prices. Care must be taken with such interpretations, but these issues should be greatly mitigated in future instantiations once US regulations are modernized.

Contractability will always be a challenge though, that is, making sure the hedge actually hedges. We really only care about our effective rates, and the highest marginal rate is only part of that equation. The many specific credits in Obama's tax plan underline this challenge. (I thought his advisor Austan Goolsbee was a proponent of tax code simplicity?) Still, while there is basis risk in the contract design, the highest marginal rate is the most tractable proxy for effective rates, especially for who one imagines to be the typical Intrade investor.

Going forward, it's imperative that policy-makers do not view such markets with hostility. It's difficult enough to design a contract that hedges an event outside of anyone's control. We don't want to get into a situation where legislators are reacting to the design of contracts and frustrating their usefulness with unexpected changes. (Clearly contracts should refer to outcomes like tax rates, and not specific bills.) We have to continue to demonstrate the desirability of these markets both in terms of price discovery and hedging. Policy-makers should consider them to be helpful insofar as they: (1) are informative about the consequences of competing policies, as with Robin Hanson's "decision markets", and (2) ease log-jams through their hedging function that allows private interests to essentially meet each other half way.

To this end, it is encouraging to see Austan Goolsbee write things like this on the advantages of market predictions. It is even more encouraging to hear from Jason Furman, Obama's Economic Policy Director, that the most important question to Obama is, "What does Paul Volcker think?" But why do I get the feeling that is hyperbole offered to placate certain undecideds?


Intrade said...

loudnotes said :

    I think it rather important in promoting the role of futures contracts not to overstate their predictive power. Irrespective of market liquidity, Intrade futures represent not the imputed likelihood of uncertain events, but their imputed perceived likelihood. The distinction is critical; it is misleading to suggest that prices reflect probabilities, when in fact they represent aggregated expected probabilities. This is an actual/notional difference; they are not the same thing.

For example, an Obama contract trading at 85 implies that market participants believe there is an 85% change of an Obama victory. The actual likelihood of his election depends on factors independent of conventional wisdom. Arguably the willingness of participants to wager money on the outcome is a reliable aggregation of those factors (the possibility of sudden surges in popular opinion, a "November Surprise" etc.), but there are biases in the market prices. For instance, the risk/reward tradeoff may be too high for buyers despite polling models that simulate an Obama victory 97% of the time (fivethirtyeight). On the other hand, conventional wisdom and investors often misperceive the probability of outlier events, which due the lack of historical basis are difficult to quantify in any case.

I don't quibble with the informational importance of these markets or of better regulation in general, but it seems wrongheaded to argue "The tax contracts can be interpreted as revealing the probabilities of tax changes conditional on who wins the election" or "Once the election is over, the contracts will continue to reflect the likelihood of legislation passing." Instead, argue that the markets reveal what people are thinking or what people expect. Expectations, unfortunately, do not always accord with reality.

Intrade said...

said :

    We are talking about markets traded by humans so of course we are talking about *perceived* probabilities. No-one argues otherwise.

Yes, aside from erroneous beliefs, there are well-known distortions that can occur in binary market prices, especially near the extremes.