July 13, 2016
I will make two quick points on the financial transactions tax (FTT) proposed by Representative DeFazio in his bill, “Putting Main Street FIRST: Finishing Irresponsible Reckless Speculative Trading Act.” Since they are really the same point, I will be very quick.
First, ordinary investors will not pay this tax.
Second, the tax will raise a great deal of revenue by making the financial sector more efficient.
The first point is a simple one. Most research indicates that the volume of trading will fall by a larger percentage than the increase in trading costs from the tax. In its analysis of a financial transactions tax, the non-partisan Tax Policy Center of the Urban Institute and the Brookings Institution assumed that the reduction in trading volume would be 25 percent larger than the increase in trading costs resulting from a FTT. This means that if a FTT raised trading costs by 10 percent, then the reduction in the volume of trading would be roughly 12.5 percent.
If trading volume falls by 12.5 percent, while the tax increases trading costs by 10.0 percent, then investors will actually be spending less on their trading in total. While each trade may cost them more money as a result of the tax, the fact that they are doing less trading more than offsets the increase in cost.
While any individual trade can have a winner and a loser (someone benefits by buying low or alternatively by selling high), trading on net is largely a zero-sum game. This means that if investors save money by trading less, they will not be harmed by the tax and may well end up better off.
What is clear is that the financial industry will collect less revenue as a result of the tax. The Tax Policy Center’s assumption that trading volume falls by 25 percent more than the size of the tax means that if the tax were to raise $40 billion a year, the financial industry would see a decline in revenue of $50 billion a year, even assuming that the tax was fully passed on to investors.
Naturally this loss of revenue will make the industry unhappy, but from the standpoint of the economy it is a clear gain. If the volume of trading is not leading to a better allocation of capital, then eliminating excessive trading is simply eliminating waste.
Everyone recognizes the importance of a well-functioning financial system to transfer capital from people who want to save, to businesses that want to invest, and to families that want to borrow. However, there is little evidence that the explosion of trading in the last four decades has improved this process. If the volume of trading is reduced by 25 or 50 percent — back to the levels of the 1990s — it is hard to believe that the ability of the financial system to allocate capital will be impaired. Instead we will have just eliminated a vast amount of waste in the financial sector. And that is a very good thing.