Reforming derivative taxation

In the absence of comprehensive reform, it is impossible to tax financial derivatives in a manner that meets any accepted benchmark of an effective and efficient capital income tax. There is no doubt that the existing patchwork of rules for the taxation of derivatives is full of holes. Most knowledgeable observers would agree that derivatives-based tax reduction strategies lead to serious revenue losses and endless wasteful efforts by sophisticated taxpayers and their advisors to stay one step ahead of the regulators. Beyond this general statement, however, little can be said with any confidence. This is because while any study of taxpayer responses to tax rules and their changes is difficult, the difficulty increases by orders of magnitude when the focus turns to derivatives. A fundamental reform of derivatives taxation is important, but it is hardly the only important fundamental reform worth considering and being considered. Other reforms, if undertaken, will affect the need to resolve the problems with taxing financial products in a variety of ways. Some reforms will make fixing the taxation of derivatives even more urgent, some will make it less essential, and some will have uncertain effects, as the following discussion explains.