Taxing Financial Transactions: Good Idea or Not?

After nearly a year of rising stock prices, with falling unemployment (albeit rather slowly) and higher than expected economic growth, there's been a decided change in the commentary from many in the media.  The pitchforks and torches have been put away, and being an investment banker is no longer something you don't mention out in the bars.  The question has begun to shift from “How do we recover?” to “How do we prevent this type of thing from happening again?”

One potential answer to the latter question is to start taxing financial transactions.  A financial transaction tax (or FTT, to save me some typing every time I mention it through the rest of the article) would be a small tax on most types of investments commonly traded, such as stocks, bonds, options, futures, and swaps.   The goal is to increase the stability of the markets by increasing the costs of buying and selling financial instruments, thus decreasing the volatility of the market (and earning the government a little money on the side).

The tax would be 0.25% on stock transactions and 0.02% on bonds, futures and swaps, with options taxed according to the underlying value of the security which it is optioning.  (Mutual funds would be affected indirectly; while mutual fund purchases or sales would not be taxed at the individual level, the purchases within the fund will be taxed, increasing the expense ratio.  I didn't find any explicit comments on how ETFs would be taxed, but since they are bought and sold on the same exchanges as stocks, I would guess that the same 0.25% stock FTT rate would apply.)

This tax would be pennies on the dollar
This tax would be pennies on the dollar

The FTT is being designed to avoid affecting small investors as much as is possible.  In addition to the small amount of tax being considered, the tax as proposed at the end of last year would not apply to mutual funds (as mentioned already), pension funds, or retirement, education or medical savings accounts.  Further, the tax would be offset for small investors by a $250 tax credit, enough to offset the costs of investing $100,000 in stocks during the year.

National Effects

-Increasing the Cost of Trading: While the tax is on the small side, it will increase the cost of trading, particularly for large and/or frequent transactions.  Some of these costs will be passed onto individual investors regardless of the intent of the law; for stocks, this could mean higher trading costs at all levels, while it will mean higher expense ratios for mutual funds.

-(Possibly) Decreases the Amount of Short Term Trading that Occurs: The stated goal of the tax is decrease ‘churning', rapid and repeated short term trading that adds little real value to the economy but increases the volatility.  Of course, how much of an effect such a tax will have is up for debate; compared to the costs charged by brokerages to buy and sell most financial instruments, the tax is rather negligible.

-Raise Tax Revenue: A study by the Center for Economic and Policy Research (CEPR) notes that this type of tax could generate a sizable amount of income.  Even with a fifty percent reduction in trading volume (cutting the amount of all financial instruments being traded in half), the tax could still raise more than $175 billion each year (over $350 billion if trading volumes remain where they were in 2008).  Granted, when the government routinely runs budget deficits in excess of one trillion dollars, even the most optimistic projections mean that this won't be enough to plug up the deficit, but it represents one more source of funds available to the government.

Personal Effects

-For the Passive, Buy-and-Hold Investor-Not Much: As mentioned, the tax is pretty small; if you aren't buying and selling repeatedly throughout the year, you'll incur rather little in the way of FTT tax liability during the year.  Add in the exceptions for retirement and other tax-advantaged accounts and the tax credit to offset small investors' expenses, and there's a good chance that you'll end up profiting from this tax.  The only real problem you have is that the expense fees of the mutual funds in which you invest will increase, as they pass the expense of the tax onto you.  However, as the Financial Adviser magazine notes, the increases will be rather small; actively managed funds will see an expense fund bump of 0.15%, while index fund fees will go up 0.05%.  At worst, that's about a 50% expense fund bump to the lowest of the low index funds.

-For Active Traders-Could Have a Larger Impact: If you're buying and selling multiple times in a month, a week, or even each day, the impact of tax will be much greater.  The cost of the FTT on a $1000 transaction is only $2.50, but if you do ten of those each day, two hundred days each year, that's a total cost of $5000 each year that you'll have to pay toward the FTT.  Of course, let's put that in perspective; if you're paying $5 per transaction each time you buy and sell stocks, you'll end up spending $10,000 in commission costs, twice the amount you'd pay in the tax.  It will increase your expenses, of course, but that's all part of the plan, to convince you to trade less often.

My View

Being a passive investor (as well as someone young enough to worry about spending much of my life paying extra taxes to cover the national debt), I like this plan.  It seems to be a pretty good method of raising tax funds, decreasing speculation, and encouraging a more passive approach to investing.  I approve.

(To be fair and try to give some time to the opposite side, here's an argument against the FTT (or Tobin Tax, another term for this type of tax), although it seems to argue most strongly that building a ‘financial security fund' from the FTT in order to bail out financial institutions in the future is impossible, because the government will spend it well before we reach another financial crisis.  You'll get no argument from me there; but if we just pour the money raised into the general fund from the start, I still don't see much of a problem.)

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