In recent weeks, as we’ve debated tax policy in light of the looming “fiscal cliff,” one idea that has been floated as a good way to generate extra revenue is a Financial Transactions Tax. It’s been getting a lot of support, including from Elliot Spitzer and Ralph Nader. Basically, a financial transactions tax (FTT) would be just that — a tax levied on each incident of a financial transaction, calculated as a very small percentage of the face value of the asset. The percentages we hear proposed are often in the range of 1 cent on every $100 transaction (i.e., .01%).
Would an FTT be a good way to raise extra revenue (or replace other revenue sources)? To answer this question, I think we need to answer two others. First, what is it that we want traders and trading in the finance industry to do? And, second, how would an FTT impact that?
There are a few things we definitely want from financial markets. First, we want them to use our savings to invest in productive ventures that can satisfy human needs now and in the future–that is, we want them to efficiently allocate capital. Second, we want them to help us redistribute risk — futures contracts on wheat, for example, allow more of us to share the benefits to, and pad the harms to, farmers whose harvests are subject to unpredictable weather events. And third, we want the assets traded in financial markets to be liquid–if you’re a saver/investor who suddenly needs/wants cash, you want to be able to sell your claims to any financial assets quickly, and at a fair price. That liquidity will encourage you to get into the market in the first place, and make your life (or, if you are a business, your financing projects) a lot easier. Now, venture capitalists, investment bankers, etc., help provide the first kind of thing–connecting our savings to long-term funding for valuable projects, etc. But shorter-term traders are essential to providing the latter–liquidity. Because traders are trading these assets on short-term bases, they ensure that there is always a market for the asset they are trading. Liquidity is why you always know, up to the minute, how much your stock portfolio is worth (the $ value you see is, fundamentally, the sum of the last transactions traders made in the underlying assets), but you’re never quite sure exactly how much your property could sell for.
Financial Transactions Taxes could raise a lot of revenue, according to most estimates. But would they detract from these important functions of financial markets? The simple answer to that is: it depends on how large the taxes are. FTTs wouldn’t really interfere with the first function of financial markets too much– if you’re a venture capitalist, you’re not going to turn Facebook away just because you might need to pay 2 cents for every $100 when it’s time to sell your shares. But they could, if large enough, reduce the liquidity of some financial markets, by reducing the viability of shot-term trading. For example, if you’re a trader placing a large, short-term, highly-leveraged bet on a small price-movement you’re predicting in that asset, even a small tax could make that bet unprofitable. It’s pretty straightforward: a .02% FTT makes each trade .02% less profitable, which could cut out some short-term, highly-leveraged trades, by making them unprofitable; but it would have less impact on longer-term trades that predict a larger price movement. So FTTs can definitely theoretically reduce liquidity. But the important question is, would they hurt market liquidity enough to hurt the real economy? That’s more debatable. My own sense is that it’s hard to believe that, with American capital markets as robust and deep as they are, a .01% FTT could clog markets enough to hurt the real economy, through making savers nervous about investing the stock market, or making it hard for companies to cash out when they want to. More, its advocates claim there could be broader benefits: FTTs would decrease the profitability of super-high-frequency trading, which is generally considered socially unproductive. By curbing high-frequency trading, we would both incentivize America’s brightest minds to find more socially productive outlets, and we could also forestall events like the 2010 flash crash. We would give investors more incentive to try to predict bigger, more significant market movements, and be less focused on temporal volatility. A very small FTT, its supporters consequently claim, could raise some extra revenue from the finance industry and improve the stability and long-term focus of financial-markets trading, without substantially interfering with the functions of financial markets.
I think it’s a pretty persuasive argument, especially if we’re talking about FTT’s on the lower end of the range proposed–.01%, etc.
Why might we oppose an FTT? I can think of four possible objections:
(1) You might think, for much broader ideological reasons, that the amount of revenue the federal government takes in is quite enough already, thank you very much. You might think raising extra revenue will just give it more room to continue to fail to curb expenditures. But if this is your objection, you should probably still at least be able to support substituting an FTT for other, worse, more distortionary taxes–i.e., you should get behind a revenue neutral reduction in income or corporate taxes offset with a higher FTT.
(2) You might worry about the potential for offshoring. That is, you might think America’s global economic leadership is an inherently good thing, and worry that, if the U.S. institutes an FTT while its competitor nations do not, then firms that profit from HFT may move offshore, focus more on foreign exchanges, pressure other companies to list abroad, etc., etc. Theoretically, this could drive the finance industry–and the larger economic ecosystem it helps support–out of NY and Connecticut. That could be bad.
(3) You might worry that, given popular attitudes toward the finance industry, an FTT, once implemented, would inevitably be raised to the point where it would reduce market liquidity. This is a slippery slope argument, which is formally considered a logical fallacy, but in this case seems like a plausible prediction, and something to be guarded against.
(4) You might also worry how the compounding effects of the FTT could eat into, say, someone’s retirement savings invested through a mutual fund. I don’t have the energy to do the calculations right now, but it seems to me that even a .02% tax, levied on a portfolio that turns over, say, three times per year, could add up to a significant dent over 30-40 years. I would hope that, if we did levy FTTs, we might be able to find some way to make exceptions for long-term retirement savings invested through mutual funds by non-super-rich people, etc.