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What the heck is a derivative and why do we care?

A derivative is a financial instrument whose value and performance depends on another asset. For example, let’s say a lender owns mortgages worth $100 million. The lender can bundle those together and sell interests in the mortgage pool until all $100 million worth is sold. But if, instead, he sells derivatives contracts whose performance is tied to the performance of the mortgage pool, the lender can sell many times the original face value of the mortgages. As a result, he magnifies the return and also the risk of the pool of mortgages. Anyone remember AIG and the 2008 financial crisis?

The advantages and disadvantages of derivatives are many, but I’d like to focus on just two:

1)      the use of derivatives to game the tax system, and

2)      how derivatives contribute to the financialization of our economy.

On Tuesday the Senate Permanent Subcommittee on Investigations questioned hedge fund managers about their use of a complicated financial derivative known as “basket options” to avoid both taxes and regulatory limits on excessive borrowing. Representatives from Barclays and Deutsche Bank, which developed the strategy that they sold to hedge funds, also testified.

It’s just the latest in a series of investigations about the misuse of derivatives for tax purposes. See, for example, earlier reports about the J.P. Morgan Whale Trades and how offshore entities use derivatives to dodge taxes on U.S. dividends. While there are plenty of reasons why financial managers use derivatives, chief among them is avoiding taxes.

Tax-avoidance derivatives are created to take advantage of loopholes that give some special treatment to particular taxpayers, industries, or types of income. For example, if I own a partnership interest, part of the income I receive may be ordinary income subject to my highest marginal tax rate and some of it may be long-term capital gains that are taxed at a maximum income tax rate of 20 percent. On the other hand, if I own a derivative tied to the performance of a particular partnership and I keep the derivative for at least a year, all of my income may be treated as long-term capital gains. When Congress got wind of this game, they shut it down some years ago.

Unfortunately, Congress just can’t keep up with all of the derivatives that the financial industry invents to game the tax system. That’s the main reason why we need a tax system that taxes all kinds of income at the same rates. Whenever Congress passes a special rule that benefits a certain type of transaction or taxpayer, tax attorneys and accountants quickly come up with ways for their wealthy clients to qualify for the tax break in ways that Congress never intended.

Derivatives also contribute to the financialization of the economy—an increase in the size and importance of the financial sector relative to the overall economy. In 1950, financial services accounted for 2.8 percent of the U.S. gross domestic product. By 1980, that number was up to 4.9 percent and in 2008 in was 8.3 percent.

At some point—and many believe we are there or way past there—continued financialization of the economy has major negative consequences: rising inequality, reduced investment by other sectors, and risk magnification, just to name a few. Derivatives not only add to but compound these negative consequences because there is no limit to the amount of derivatives that can be issued.

Derivatives have another ugly side: many are created in offshore tax haven jurisdictions because they cannot be legally used in the U.S. (or other real countries). The derivatives that contributed to the collapse of Enron at the turn of the millennium and the staggering losses of AIG and other financial institutions in the 2008 financial meltdown were mostly related to transactions in offshore jurisdictions.

Kudos to Sen. Levin and the Permanent Subcommittee on Investigations for putting the spotlight on this important issue. A functioning Congress would take quick action to fix the problem. Sadly, however, too many of our legislators are fervent supporters of evil behavior when it comes to taxes.