Transactions Tax Likely to Cause More Damage to Financial Markets
This is the second part of a two-part article on damaging new taxes that some federal legislators are considering imposing on investors and entrepreneurs.
Last month's article discussed “carried interest” taxation. Carried interest, also known as a profits interest, is a business arrangement where a partner receives a share of the income of the business venture in exchange for providing services. Unlike other partners, carrying partners provide services and do not have to contribute capital, nor do they necessarily have to be allocated any of the losses. This is where we get the term “carried” because the other partners who provide all of the capital for the venture are figuratively “carrying” the profits interest partner.
Here in part two the focus turns to proposals to impose taxes on financial transactions.
By Jeffrey V. McKinley
In addition to “carried interest” taxation, another tax threat to the financial industry is the proposed financial transactions tax, sometimes called a “Robin Hood” tax, the idea being that it takes from the rich. The financial crisis and subsequent bailout of banks and brokerage and trading firms created a backlash against those companies and calls to have them “pay for the crisis they caused and the bailouts they received.” One method to accomplish this and other goals is to impose a tax on financial transactions. Bills doing this have been introduced in committee in both the U.S. Senate and the House.
The bills are titled the “Wall Street Trading and Speculators Tax Act.” They would impose a 0.03 percent excise tax on stocks, bonds and derivatives. The proponents of the bills claim they are needed to raise revenue. They project revenues of $352 billion in 10 years as well as promising they would reduce the volatility of markets.
Proponents of the transactions tax claim that some short-term traders harm the markets with their rapid buying and selling, primarily by increasing volatility. Even if there were some market participants who through their short-term trading disrupt the market, which is debatable, a tax would be a very blunt instrument to combat this supposedly harmful activity. Moreover, it runs the real danger of harming other beneficial market participants such as arbitrageurs who play a vital function of providing liquidity by weaving together interrelated markets worldwide.
Further, these claims of being able to reduce volatility through a transaction tax are questionable as many studies have concluded that these types of taxes do not reduce volatility and in some cases end up increasing volatility.
Long History of Proposals
Financial transactions taxes have been proposed pretty much since the creation of organized trading and investing itself. The concept of a financial transactions tax was initially proposed by John Maynard Keynes in 1936 in an attempt to curb speculation, and again in 1972 by economist James Tobin, the namesake of the Tobin Tax. Tobin suggested that a targeted tax on foreign currency transactions would reduce volatility in the marketplace after the 1971 closing of the gold window, which ended the convertibility of dollars into gold and resulted in floating exchange rates.
The United States has had other proposals. In 1987, House Speaker Jim Wright (D-Texas) proposed a fee of 0.25 percent to 1 percent on both the buyer and the seller in each securities transaction. In 1990, President George H.W. Bush proposed a 0.5 percent tax. In 1993, the Clinton Administration proposed a tax of a fixed amount, 14 cents, on futures transactions. And now we have the 0.03 percent tax proposed by Senator Tom Harkin (D-Iowa) and Rep. DeFazio (D-Oregon).
Financial transactions taxes have also been the preferred revenue raiser for multiple bills to fund measures ranging from boosting employment to access to dentists to climate change mitigation.
Harmful Experience Starting in 1960s
The United States has experienced the harmful effects of transactions taxes in the past. In the 1960s, the Eurobond market was emerging with New York being the center of activity. However, in 1963, the U.S. Interest Equalization Tax was passed placing a tax that ranged from 1.05 percent to 22.5 percent on bonds depending on their maturity. Over the next seven years, Eurobond issues in London increased more than 18-fold while New York lost jobs in that sector. The tax was repealed in 1974, but it was too late for New York to reestablish the lead for the market.
In 1984, Sweden imposed taxes on securities transactions at a rate of 0.5 percent and then doubled the rate to 1 percent in 1986. The apparent impetus for the tax was popular envy of the salaries being earned by the country’s young financial professionals. The effects on the stock markets in Sweden were pronounced. Tax revenues amounted to only about one-thirtieth of the amount forecast. After the doubling of the tax rate, 60 percent of the volume of the most active 11 stocks traded in Sweden shifted to London, and fixed-income trading dropped 85 percent. The taxes were abolished in 1991, and trading volume and tax revenues rose significantly.
An October 2011 report from the CME Group summarized 17 different studies of the effects of a transaction tax. Of those 17 reports, six examined the impact on tax revenues. Four of the six showed tax receipts below expectations, one showed tax receipts higher than expected, and one showed only temporary success generating higher tax revenues. Ten of the studies researched the impact on liquidity, with nine of them showing lower liquidity. The tenth liquidity study was inconclusive. Results were likewise with volatility. Of the nine reports that studied volatility, seven showed higher volatility, one was inconclusive, and one showed no effect.
Serious Damage to Futures Industry
Now let’s turn our attention to the impact a financial transaction tax would have on futures trading given its special importance to the local economy of Chicago and the global economy in general. The Chicago-based CME Group comprises 98 percent of total futures trading in the U.S. and 6 percent of total corporate tax receipts of Illinois. The 6 percent figures does not count the revenue streams from trading firms, individual traders and businesses affiliated with trading. In short, vibrant futures trading is important in many aspects.
The current proposals for a 0.03 percent tax are particularly detrimental to futures trading. This point is lost on the proponents of the tax. This oversight is primarily due to the scoring models that are used to assess the potential effects on the marketplace and amount of tax revenue. These models are based on securities trading, not futures trading, and as such grossly underestimate the elasticity of demand of futures markets primarily due to global competition. Anyone who is familiar with the modern-day trading environment understands that access to another market in the far corners of the world is simply a mouse click away. Impose taxes on one market, and volume will simply switch almost instantly to markets with lower taxes.
A study conducted in 2012 to assess the impact of a tax of 0.02 percent on futures transactions predicted that, if the tax were implemented, you wouldn’t just see a drop in volume but the total elimination of all volume in six U.S. futures contracts including the S&P 500, and other U.S. futures contracts would suffer large drops in volume.
A 12,000% Tax Increase
This is understandable, as a tax of 0.03 percent, which is touted as a tiny tax by some, is an increase in transaction costs for some market participants by a factor of 12,000 percent. For example, a Treasury Note contract with a notional value of $100,000, would have a tax imposed of $30. Most professional traders are paying around 25 cents per contract. This would force many firms to instantly shut down or at the least be disruptive while they shift their volume to exchanges outside of the United States.
As we’ve seen, a financial transactions tax, like the proposal to change the way carried interest is taxed, has been shown to be very damaging to the marketplace while most likely not bringing in the anticipated revenue or the market calmness that their proponents seek.
It would be more beneficial for everyone if politicians would spend their time looking to reduce government spending as opposed to adding additional complexity to the tax code and disrupting business activity as they seek out new revenue sources.