he Economic Recovery Tax Act of 1981 (hereinafter called the Act) significantly T changed the taxation of profits' on futures contracts which were not hedges.'
In this article, the methods of taxation of such profits before and after the Act are reviewed. Because the Act changed the incentives for trading in different contract months, one would expect the distribution of volume among contract months to have changed after the Act. The results in this article indicate that there has been a significant change in the distribution of volume for some commodities which might be attributable to the tax legislation.
TAX ENVIRONMENT BEFORE THE ACT3
Before the Act, profits on futures contracts which were not hedges were taxed in the year in which the futures contract was liquidated. If the taxpayer took delivery on a futures contract, the total profits were taxed in the year in which the delivered property was sold. Taxpayers conducting cash-and-carry transactions were allowed to deduct those costs incurred in holding the physical commodity in the year in which the costs were i n ~u r r e d . ~
Before the Act, profits on a long futures position were taxed as short-term capital 'Throughout this article, the term "profits" is used to denote profits or losses, i.e., profits may be positive or negative.
"The Act specifically states that it does not apply to bonafide hedging transactions. Profits on hedges continue to be taxed as ordinary income.
'For more discussion of the tax environment before and after the Act, see Arthur Andersen (1982, 1984), Bowers (1981, 1982), Goldfein and Hochberg (1968), and Straws.
Typically in a cash-and-carry transaction, an individual holds a spread position, i.e., a long position in one contract month and a short position in a more deferred contract month. The individual takes delivery on the long position, finances the physical commodity, and delivers the commodity against the short position. An individual may also conduct a cash-and-carry transaction by acquiring the physical commodity in the cash market. holding a short futures position, and delivering the commodity at contract maturity.