Tax treatment of trade in live cattle futures using a mean variance approach: implications to market efficiency and welfare changes

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Virginia Tech


Cattle feeders are in a position to incorporate the influence of current and highly specific information into price discovery processes for live cattle and feeder cattle futures. The tax treatment of speculative trades in the cattle futures markets has the potential to effective block participation of cattle feeders, however. To the extent that cattle feeders are effectively blocked from trading in futures in any capacity other than trades that meet the simplistic IRS "equal and opposite" criterion of a hedge, the correction of market imbalances may be slowed. The economic viability of investments in cattle feeding and the well-being of the consuming public can be influenced in a significant way by prolonged market imbalances.

A theoretical model is developed based on a mean-variance approach. The model deals with the simultaneous determination of optimal cash and futures positions given tax parameters of marginal tax rate and percent of deductibility of any futures losses. Producers' risk aversion is considered. This research examines the impacts of changes in tax policy on the optimal cash and futures positions, equilibrium prices, pricing efficiency, welfare changes in both cash and futures markets, and on tax revenues. Comparative static analyses are performed to examine the changes in the measures of efficiency and/or welfare given a unit change in the tax parameters. A revenue-neutral tax scheme is incorporated into the model to analyze the comparative statics when tax receipts are fixed.

The simulation results indicate that given a marginal tax rate, an increase in the probability of deductibility of any futures losses would increase both the optimal cash and futures positions. The adjustments of the optimal cash and futures positions reduce the spreads between expected cash prices and marginal costs for the cash market and between the expected futures prices and current futures price (including trading costs) for the futures market. This implies that pricing efficiency in both the cash and futures markets is improved by an increase in the deduction level for a given tax rate. Both producers' and consumers' welfare increases in response to the increased probability of deductibility for a given tax rate. Expected tax revenues become positive and increase as the deduction level increases.

The comparative static analyses generally support the empirical findings. A revenue-neutral marginal increase in the deductibility of losses for a given tax rate would result in a transfer of risk exposure from the cattle industry to the government sector. This has an important implication for risk-sharing aspects of a revenue-neutral tax policy, and suggests that policies should examine both the potentially variable mean-level tax revenues and variance of that revenue flow under alternative scenarios.