Securitize your tax risks

Now I know financial engineering is unpopular at the moment with the credit crunch but a new market has sprung up that could be used, if you are a US tax payer, to lower the risk of an income tax rise., or even make some cash. Intrade has a market on what the top rate of income tax will be in the years 09, 10, and 11. You could protect yourself against these rises by betting on them, thus giving you a more stable position to base your other financial decisions on.

Here's how it works in a simplified form:

say there was just one tax band on all income, for eases sake, and that band was at 35%. You earn 100k, again for eases sake. This year you will pay 35k to the Fed. The odds of a tax rise next year to 37% are 1 in 6 (as set by the market). So there is a 1 in six that you will have to pay an extra 2k. But what if you think that the government is in a squeeze and the odds really are 1 in 3. Then you can bet 1K that taxes will rise. If they do then you make money. Your extra 2k to the government is covered by your 6k winning. Net result, you gain 4k. If taxes don't increase you are down your stake of 1k. So, not only have you spread the risk of a tax rise, mitigating against the shock to your disposable income, but you also can make some cash. You reckon the odds are 1 in 3 so your net gain is 4/3 - 2/3 = 2/3k.
Of course, the example is over simplified. In this example, you come out winning. However, there is a benefit in the neutral position because you have spread your risk. Cool huh? See, financial markets aren't all bad.


Hat tip: Greg Mankiw for alerting me to the new market.