Most wages are paid at the gong of a bell and most people eat their wages and can’t put off their hunger too long. So, wages that are consumed can be taxed at the gong of a bell. Taxes on wages constitute the vast majority of the tax receipts of the United States. (1) It is great luck for the tax system that people who eat what they earn still walk the earth.
Then there are increases and decreases in wealth— a kind of income — that don’t feed hungry mouths and can be made to happen any time —deferred or accelerated, hidden, eliminated. And the tax law has a hard time deciding whether to tax these changes in wealth, how to tax them, and when to tax them.
And so — mark to market.
Mark to market is a tax gong for transactions that
generate cash at odd moments: whenever it’s convenient for everyone. If taxpayers entering into derivatives can ensure they’ll collect cash with interest on their transaction then they mostly don’t care when they receive it (especially if changing the day of receipt saves taxes).
Take for example a swap,2 a contract that normally requires payment of amounts on a regular schedule. But in practice as long as the collateral is posted and rights can be enforced, a party can fulfill its obligations under the contract at the inception of the contract or at its completion or every second Tuesday except if it’s a British Bank holiday. Then the tax law needs to decide if the payments should be taxed whenever they’re paid or some other time.
Take another example, a forward contract,3 which normally requires payment at termination. But to take advantage of tax rules, people invented
prepaid forwards, and variable prepaid forwards, so that parties to forward contracts can control when they receive payments and how much tax they pay on those payments.
If everything else is equal it shouldn’t matter which year tax is paid or who pays the tax, but everything else is never equal and Congress cares when tax is paid and who pays; it doesn’t like taxpayers sharing their income and losses between each other nor does it like taxpayers moving their income and losses backward and forwards in time too much. But derivatives allow taxpayers to reduce their taxes by timing when they recognize income and loss, for example, to use up net operating losses, or expiring capital losses.
And even when Congress decides to advantage one type of income over another, such as long term capital gains over earned income, it doesn’t intend to make tax rates elective by using complex transactions for which the tax rules are unclear, like bullet swaps and prepaid forwards.
So plebeians pay tax regularly at ordinary income tax rates on the easy target of wages and the others choose when and how and how much tax they pay if they know how to arrange the bits and pieces of tax rules to suit them.
And so — mark to market