Parsing a Financial Transactions Tax

by Timothy Taylor, Conversable Economist

Controversies over a financial transactions tax have a long history in economics (going back Keynes’ advocacy of such a tax in the 1930s) and public policy (the British have imposed a “stamp duty” on stock transfers over more than three centuries from 1694 to the present).

Leonard E. Burman, William G. Gale, Sarah Gault, Bryan Kim, Jim Nunns, and Steve Rosenthal take stock of the issues in “Financial Transaction Taxes in Theory and Practice,” published as a June 2015 discussion paper by the Tax Policy Center. Here’s the summary of the arguments for and against (citations omitted):

“Proponents advocate the FTT [financial transactions tax]on several grounds. The tax could raise substantial revenue at low rates because the base—the value of financial transactions—is enormous. An FTT would curb speculative short-term and high-frequency trading, which in turn would reduce the diversion of valuable human capital into pure rent-seeking activities of little or no social value. They argue that an FTT would reduce asset price volatility and bubbles, which hurt the economy by creating unnecessary risk and distorting investment decisions. It would encourage patient capital and longer-term investment. The tax could help recoup the costs of the financial-sector bailout as well as the costs the financial crisis imposed on the rest of the country. The FTT—called the “Robin Hood Tax” by some advocates—would primarily fall on the rich, and the revenues could be used to benefit the poor, finance future financial bailouts, cut other taxes, or reduce public debt.

“Opponents counter that an FTT is an “answer in search of a question”. They claim it would be inefficient and poorly targeted. An FTT would boost revenue, but it would also spur tax avoidance. As a tax on inputs, it would cascade, resulting in unequal impacts across assets and sectors, which would distort economic activity. Although an FTT would curb uniformed speculative trading, it would also curb productive trading, which would reduce market liquidity, raise the cost of capital, and discourage investment. It could also cause prices to adjust less rapidly to new information. Under plausible circumstances, an FTT could actually increase asset price volatility. An FTT does not directly address the factors that cause the excess leverage that leads to systemic risk, so it is poorly targeted as a corrective to financial market failures of the type that precipitated the Great Recession. Opponents claim that even the progressivity of an FTT is overstated, as much of the tax could fall on the retirement savings of middle-class workers and retirees.”

Their paper offers an overview of the current uses of a financial transactions tax and the existing evidence on these various claims. Without attempting to be in any way exhaustive, here are some of the points that caught my eye:

The US has had financial transactions taxes in the past, and continues to have such a tax at a low level today.

“From 1914 to 1966, a federal FTT was levied on sales and transfers of stock. The rate was originally 0.02 percent of the stock’s par value …In 1959, after firms had become practiced at manipulating par value to avoid tax, the base was changed to market value, and the rate was cut to 0.04 percent. From 1960 to 1966, stocks were taxed at the rate of 0.10 percent at issuance and 0.04 percent on transfer. … In 1934, the Securities Exchange Act (Section 31) granted the SEC the authority to fund its oversight operations with fees on self-regulatory bodies such as the New York Stock Exchange. At present, a 0.00184 percent fee is levied on sales of securities, and a $0.0042 fee per transaction is levied on futures transactions. Debt instruments are exempt from the tax.”

Many other high-income economies have financial transaction taxes now, although others have recently repealed such taxes.

“Many G20 countries tax some financial transactions. The most common form is a tax on secondary market equity sales at a rate of 0.10 to 0.50 percent. Such taxes were imposed, as of 2011, in China, India, Indonesia, Italy, South Africa, South Korea, and the United Kingdom. Italy, Russia, Switzerland, and Turkey imposed taxes and/or capital levies on debt financing, typically on issuance rather than on secondary markets. But many developed nations have repealed FTTs in recent decades, presumably because of competitive pressures stemming from globalization and technological changes that have made remote trading less costly. Germany, Italy, Japan, the Netherlands, Portugal, and Sweden have repealed STTs [securities transaction taxes] in the last 25 years.”

The design of a financial transactions tax requires answering a number of questions, and just listing the questions helps to understand the possibilities for shifting and reformulating financial transactions in ways that would reduce the reach of such a tax.

“The first design question is the geographic reach of the tax. Should the application of the tax turn on the residence of the issuer of the security; the residence of the buyer, seller, or intermediary; or the location of the trade? … Second, which securities are covered by the tax: stocks, bonds, derivatives? … A third issue is which financial markets are subject to the FTT. Does the tax apply only to exchange-based transactions or also to over-the-counter transactions? … A fourth issue is whether the tax excludes market makers. … Most recent proposals choose to tax market makers. A fifth issue is whether the tax exempts government debt. … Turning to the tax rates, there are further questions. Is the tax ad valorem or a flat fee per share traded? … A final issue is whether the tax is coordinated internationally.”

The question of whether a financial transactions tax would hinder financial markets from working well or would discourage speculative trading and pointless volatility is undecided in the research literature.

“[A]lthough empirical evidence shows clearly that FTTs reduce trading volume, as expected, it is unclear how much of the reduction occurs in speculative or unproductive trading versus transactions necessary to provide liquidity. The evidence on volatility is similarly ambiguous: empirical studies have found both reductions and increases in volatility as a result of the tax.”

Overall, the dogmatic argument that a financial transactions tax is unworkable is clearly false. It operates in a lot of countries. The wide-eyed hope that such a tax can be a truly major revenue source also seems to be false. In part because of concerns over the risk of creating counterproductive incentives–either just to structure transactions in a way that minimizes such a tax or even to react in a way that reduces liquidity and increases volatility in financial markets–the rate at which such taxes are set is typically pretty low. As the authors write,

“the idea that an FTT can raise vast amounts of revenue—1 percent of gross domestic product (GDP) or more—has proved inconsistent with actual experience with such taxes.”

The question with any tax is not whether it is perfect, because every real-world tax has some undesirable incentive effects. The question is whether a certain tax might have a useful role to play as part of the overall portfolio of real-world taxes. For what it’s worth, this particular review of the evidence leaves me skeptical that expanding the currently existing US financial transactions tax from its very low present level would be a useful step. The authors of this paper are careful to adopt a fairly neutral on-the-one-hand, on-the-other hand pose, without making any firm recommendation. But in the conclusion, they do write:

An FTT at the rates being proposed and adopted elsewhere would discourage all trading, not just speculation and rent seeking. It appears as likely to increase market volatility as to curb it. It would create new distortions among asset classes and across industries. As a tax on gross rather than net activity, and as an input tax that is not creditable and thus cascades, the FTT clearly can most optimistically be considered a second-best solution. Over the long term, it appears poorly targeted at the kinds of financial-sector excesses that led to the Great Recession.