Tax Hedging?

Over at Intrade, you can bet on future tax rates. Currently, the implied probability of a hike in the top income tax rate in 2009 is about two-thirds.

This surprises me. Even assuming an Obama victory, I would put the probability much lower. As an economic matter, raising anyone's taxes with the economy so weak seems ill-advised. As a political matter, why not just let the Bush tax cuts expire at the end of 2010? Obama could then claim in four years that he never signed a tax hike. It seems neither economically nor politically sensible for the new President to push for an immediate tax increase, even if an eventual tax increase is his goal.

How then to explain the betting at Intrade? I can think of three hypotheses:

1. The Obama people are not as savvy as I think they are and will push for an immediate tax hike.

2. The Intrade market is so thin that the pricing there does not mean much.

3. Some people are using the Intrade market as a hedge. A high-income person bets that tax rates will go up and bids up the implied probability above the true probability. If the bet pays off, his winnings reduce some of the hit his after-tax income takes by the tax change. It is a form of insurance. Those traders on the other side of this bet--who win if taxes do not rise--are buying a high-risk asset, as measured by covariance with their consumption. They need to be compensated for taking this risk. Under this hypothesis, the Intrade price is not a good gauge of the actual probability but includes a substantial risk premium.

Update: Tony Smith, an economics professor at Yale, emails this comment:

Dear Greg:

I read with great interest the post on your blog today about how to interpret the prediction market price for the event of a tax hike in 2009. Tyler Cowen made a similar point about interpreting the market price for the event that Congress would approve a bailout before September 30. And, in fact, last May I wrote a comprehensive exam question for the Ph.D. students at Yale that revolved around this same observation in the context of an election prediction market. But I have seen no formal papers that make this point. I think it is a critical one for evaluating the usefulness of prediction markets in aiding decision-making.

The general point that rational investors will use prediction markets to hedge risks can also help to explain an apparent puzzle throughout the recent election campaign: in particular, statistical models designed to predict election outcomes (see, for example, www.fivethirtyeight.com and David Stromberg's website) generally reported probabilities for an Obama victory that exceeded the corresponding market prices on both intrade and betfair. If we take seriously the predictions of these statistical models--that is, if we view them as giving an accurate estimate of the actual probability that Obama will win--then evidently investors seem to think that Obama will be relatively good for the economy compared to McCain, driving down the equilibrium price for an Obama contract (since this contract pays off when marginal utility is low). To help voters make an informed decision, maybe you should post this "evidence" on your blog!

Regards,

Tony Smith

Thanks, Tony.

Sowell lets loose

Economist Thomas Sowell really, really, really does not like the Democratic ticket.

Shiller on Groupthink

Yale economist Bob Shiller discusses why bubbles are hard to diagnose.

Election Fact of the Day

Obama leads in 18 out of the 19 states with the largest recent declines in home prices, whereas McCain leads in 13 out of the 14 states with the largest recent increases in home prices.

Click here to see the data.

The Health Care Debate

David Cutler and Brad DeLong make the case for the Obama health plan. Arnold Kling dissects their analysis.

David and Brad lost me in their second sentence:

Every other North Atlantic country is healthier than America.

That falls into the category I once described as "true but misleading statements about health care that politicians and pundits love to use to frighten the public."

The Economist endorses...

...Barack Obama.

Vernon Smith on Barack Obama

A letter in the Wall Street Journal from Nobel Prize winning economist Vernon Smith:

I think the answer to Alan Reynolds's excellent question and article ("How's Obama Going to Raise $4.3 Trillion?," op-ed, Oct. 24) is that Barack Obama is not going to raise $4.3 trillion, and he is not going to perform on his rhetoric. He excels as a rhetorician -- common to both the great and the least of past presidents -- but performance cannot run on that fuel. Inevitably, I think his luster will fade even with his most ardent supporters as that reality sets in. We also have seen luster fade time after time with Republican presidents. The rhetoric of a smaller and less invasive government always leads to king-size performance disappointments. This weakness is as central to the reality of our political economy as are its strengths. With all its foibles, its strengths become transparent when you compare it, not with our various idealizations, but with the litter of human experiments in political economy that have delivered far more suffering and murder than human betterment to the citizens of those economies.

Of course it is entirely likely that Mr. Obama will succeed in going for higher business, capital gains and income taxes, but it is an economic illusion to think for a minute that this will benefit the poor. All our wars on poverty have been lost by failing to help the poor help themselves. Higher business taxes, which ultimately can only be paid by individuals anyway, will simply export more economic activity to the world economy. Higher capital gains and income taxes will primarily reduce savings and investment at the expense of greater future productivity, which is at the heart of cross-generational reductions in poverty. A dozen countries, including the third largest economy, already have zero taxes on capital gains, and eight of them score high on the Economic Freedom Index and high in gross domestic product per capita.

I favor making all individual savings and direct investments deductible from income for tax purposes. In that world there would be no need to make any distinction between ordinary income and capital gains. By adding a negative feature to such a net consumption tax, the poor would not only receive redistribution benefit, but have an incentive to save and accumulate capital. Some poor will see this as an opportunity to help themselves.

Vernon L. Smith