After our recent analysis of the impact of some of the Biden tax proposals on loss harvesting, we met several times with a number of tax experts among our clients to share our findings and listen to their views. As has often been the case in such discussions at Aperio, we learned a great deal from our clients that we hadn’t thought of beforehand. The sophisticated tax experts brought unique expertise and insights to a broader discussion about planning when tax law in the future appears so uncertain.
Among many observations and expectations about the future, a number of our client tax experts agreed that uncertainty about tax law seems unusually high right now and may soon increase further. Some speculated that major tax regime change could become more frequent as, over time, political parties trade control of the two houses of Congress or the White House.
As the tax experts shared those concerns about the future, some emphasized that for various strategies dependent on future tax treatment, some advisors now put a greater weight on flexibility than simply on the optimal economics under current tax rules. They confided that they may now give up a bit of optimal after-tax results, narrowly defined by forecasting today’s tax rules, in exchange for the ability to pivot should rates or rules change significantly. Obviously, the tax economics under today’s system still matter, but more value is being placed on flexibility.
Naturally, when quant geeks see any situation in life that reflects uncertainty, we immediately try to apply some sort of model, no matter how far-fetched its application. For uncertain tax outcomes, we’ll look to real options, a tool from corporate finance that measures the value provided by additional flexibility. Real options go beyond analyzing the feasibility of a corporate investment using only a traditional tool like simple NPV to capture the ability to shift gears more easily should market winds shift (or in our case political winds).
Example from the Petrochemical Industry
To illustrate real options, we’ll take a simple example from the petrochemical industry, specifically in the manufacture of certain plastics. Some chemical plants that make plastic can utilize either naphtha (a hydrocarbon produced at a refinery) or natural gas. Companies can build such plants to use one or the other feedstock (raw material) or, for a higher cost, with the capacity to switch between the two. That extra flexibility provides real value in that it allows a company to shift to a lower-cost feedstock depending on market conditions. The obvious question arises, “how much extra value does the flexibility provide?” Say you have to spend an additional $50 million on a chemical plant to embed such feedstock flexibility. How do you know if it’s worth the extra cost?
Real options applies traditional option pricing theory to such corporate finance situations, converting real business costs and benefits to the inputs for an option model like Black–Scholes. In this example, the extra $50 million would be the option premium. As those familiar with option theory already know, the volatility of the underlying asset exerts great influence on an option’s value. In this case, the volatility to plug into an option price formula would be the volatility of the relationship between the price of naphtha and the price of natural gas. If the prices of those two feedstocks don’t vary much, then the value of the manufacturing flexibility will remain low; whereas, if the variation in the two prices is high, then the flexibility can potentially provide a lot more value.
Inventing a New Derivative
Obviously, if we turn back to tax planning, it’s the variability of tax rates and rules that drives the value of retaining flexibility. The higher the volatility around tax rates and structures, the more benefit from flexible, all-weather investment strategies. For the stock market, a handy measurement exists in the form of the CBOE Volatility Index, or VIX, which reflects the implied volatility of US large-cap stocks. What would work for the variability of federal and state tax codes over time?
During our meetings with our clients experts, we half-jokingly suggested how useful it would be were there a derivative an investor could actually trade that would hedge against future changes in tax law. (In reality, quantifying this kind of political outcome precisely would be very hard, so for now, it remains an imaginary derivative.) Maybe we could call the tax version TIX. Unlike VIX, which reflects current market perception of volatility, TIX could be calculated based on historical tax regime changes, say, over the past century. Many significant changes in capital gain rates have occurred, and the average time between major changes could also be incorporated.
We don’t seriously propose trying to calculate a precise value for an imaginary derivative like TIX, but we do think that the concept can still be helpful in thinking about tax planning across a maddening variety of possible legislative outcomes. If you believe tax rate volatility will increase, then flexibility does provide more value if it allows a taxable investor to switch among various options to best reflect the changes in taxation. While you may not be able to calculate the value of flexibility in taxable investments as precisely as with a petrochemical plant, you can still benefit from incorporating the concept of tax regime volatility as you analyze the potential costs of choosing a more flexible investment strategy.
- Loss Harvesting with Inflation-Adjusted Gains
- Impact of Biden’s Capital Gains Proposal on the Performance of Loss-Harvesting Strategies
- What Is Tax Economics? Q&A with Aperio's Chief Tax Economist, Patrick Geddes
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