Some say that a financial transaction tax is a cost-free way to kill many a bird with one stone — raising revenue, preventing financial crashes and making markets safer. But advocates of this neat idea conveniently ignore the century of less-than-successful experience with this tax, including New York State’s own failed attempt.
The idea behind a financial transaction tax, which is a tax on individual market trades, has a smart pedigree. John Maynard Keynes suggested it, and James Tobin, a Nobel laureate in economics, was its most famous modern advocate. Tobin, who died in 2002, wanted to “throw some sand in the wheels” of the markets, and his idea, endorsed by Joseph Stiglitz and Lawrence H. Summers among others, is based on an increasingly held belief that markets are far from efficient. Imposing a transaction tax on each individual trade would eliminate wasteful trading and reduce market volatility, ending short-term speculation and mispricing of assets.
This net benefit is paired with a simple budget argument. The Robin Hood Tax campaign in Britain, for example, has used the slogan “Not complicated. Just brilliant” to support a 0.05 percent tax on transactions as an effective way to ease the budget without harming markets. Let’s face it, the banks are an easy target after the financial crisis.
It seems to be a win for everyone.
Unfortunately, the reality has been much different.
Let’s start with New York State, which has had such a tax since 1905. Over the next eight decades, the tax was revised up and down nine times, including a large increase in the middle of the Great Depression. In 1966, Mayor John V. Lindsay of New York City ended up raising the tax by 25 percent. It led to an immediate reaction as the New York Stock Exchange threatened to jump across the Hudson River to New Jersey.
In the 1970s, the tax began to be phased out. New York State still collects the tax — some $14.5 billion annually — but since 1981, the state has simply returned it to traders instead of keeping it. In other words, the tax is collected and immediately given back, something that can happen only in the strange world of taxes. (Other financial transaction taxes include a federal version, which was put in effect in 1914 to help pay for World War I and eliminated in 1966, and taxes in Massachusetts and Pennsylvania that were also done away with in the 1950s.)
A study of New York State’s tax over those eight decades by Anna Pomeranets and Daniel G. Weaver found that it increased the cost of capital for investors and reduced trading volume. Most important, they found the tax actually increased trading volatility by as much as 10 percent.
Increasing volatility is exactly what advocates of the tax don’t want. They want volatility reduced to prevent market disruptions, but the decline in traders in the markets mean fewer buyers and sellers and more price jumps. This finding of increased volatility is in general accord with nine other major papers to study this issue, including studies of the tax in 23 countries, among them Britain, Sweden and Japan. Only one of these papers found that a financial transaction tax reduced volatility.
The New York State tax experience raises a bigger issue — that of traders just going elsewhere. This problem was mirrored in Sweden.
In 1984, Sweden adopted a financial transaction tax. Some 30 percent to 50 percent of the country’s trading volume then shifted to Britain. The lower amount of trading meant that not only did the tax yield less money than predicted but that the country lost more in capital gains taxes than the financial transaction tax raised. The tax was abolished in 1991.
The Swedish and New York State examples show that not only will traders leave to trade elsewhere; the money that people think this tax will reap will not appear, as that trading migrates and volume declines. Japan decided to eliminate its financial transaction tax in 1999 for this reason.
And even if the trading does not shift to other places, financial people are adept at avoiding it. In Britain, for example, where the financial transaction tax has fluctuated from half a percent to 2 percent, the tax has raised significantly less revenue than one might expect, about £3 billion a year. The reason is that investors who trade regularly in Britain use options to avoid the tax, which applies only to trading in stock. The result may be that the tax pushes investors into more risky securities in their efforts to avoid it.
And the reduced volume does not just reduce the amount of revenue collected. It may impose the largest costs on people who cannot afford or avoid the tax. The money management firm BlackRock has calculated that if the financial transaction tax were set at 0.1 percent per trade, an investor putting $10,000 in its global equity fund would lose more than $2,300 in expected returns over a 10-year period. This amount would rise to $15,000 if the money were invested in a more actively managed European fund.
This means not only less in retirement funds, but fewer jobs. Although disputed, one study in 2004 by the Partnership for the City of New York found that if New York State started keeping a tax of 0.25 cents per share traded, it would lose 23,000 to 33,000 jobs for every 10 percent drop in volume and more than $3 billion in lost revenue and economic value, probably more than offsetting the amount it collected.
This is not to say that a financial transaction tax by itself is such a terrible idea. My point is that we already have lots of experience with this kind of tax, and it argues for caution. If you think a financial transaction tax will reduce volatility, then you have to account for the fact that taxes in the past have shown the opposite. And if the tax is not imposed globally, it will force migrations of trading to less regulated places and in more byzantine forms, possibly making the world markets less safe.
As for seeking revenue gains to solve budget problems, if the tax is too small, it will have no effect. But the larger it is — and the Robin Hood Foundation’s proposal is in the large sphere — the more markets will be affected. It is for these reasons that Canada has rejected such a tax.
Now, we are about to get a real-life case study. France has adopted a 0.2 percent financial transaction tax involving securities of a company with a market capitalization of more than 1 billion euros. The full effects of France’s tax are not yet known, but a preliminary study by Credit Suisse, according to The Economist, found that stocks not subject to a tax rose 19 percent by volume, but those affected by the tax declined 16 percent. And the net effect of the tax appears to have shifted trading to smaller stocks not subject to it, distorting the allocation of capital, which is another problem with the tax. And the European Union has proposed a tax for 11 of its member countries, giving us a possible second test.
Instead of rushing into the adoption of a financial transaction tax, it may behoove us to watch and see whether these new taxes in Europe work. And even if the United States plunges ahead, history tells us that any tax should be carefully structured and considered before being put into effect. For there are likely to be many unintended consequences. There’s a reason that economists say there is no free lunch.
Deal Professor: In Wall St. Tax, a Simple Idea but Unintended Consequences
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Deal Professor: In Wall St. Tax, a Simple Idea but Unintended Consequences
