January 20, 2012
Late last year, the Congressional Budget Office (CBO) responded to an inquiry from Senator Orrin Hatch about the potential impact of a financial transaction tax (FTT) of three one-hundredths of a percent on (1) GDP and jobs, (2) municipal financing, and (3) U.S. Treasuries.
In general, CBO responded that the FTT “could” or “would probably” cause “slight” negative effects in the short term, and it never quantifies these effects. As for long-term impact, CBO states that it does not know whether it will be positive or negative. While some media and critics have held up this letter as a major setback for the FTT, let’s take a closer look at what CBO actually said:
Question #1: What impact would the proposed tax have on gross domestic product (GDP) and on U.S. jobs?
CBO’s response:
In the short term, imposing the transaction tax would probably reduce output and employment. Beyond the first few years, however, the tax’s net impact on the economy is unclear… Employment would be unaffected in the long term.
This appears to be far from damning. CBO dilutes its assessment of the short-term impact with the qualifier, “probably,” and says that the long-term impact on GDP is “unclear” and that jobs will not be affected. In explaining its reasoning, CBO looks at effects on investment and decides to counter an argument in favor of the FTT:
Some analysts believe that… the tax would reduce volatility… [and] might discourage short-term speculation, which can destabilize markets… However, the tax would discourage all short-term trading, not just speculation—including transactions by well-informed traders and transactions that stabilize markets.
In fact, the extent to which “well-informed” traders can stabilize prices is trivial. The transactions that CBO refers to happen when there are slight price discrepancies between different exchanges, and traders make profits by capitalizing on these gaps. If, for example, the FTT were to make this trading profitable only when the gap between prices of a certain stock rose to 11 cents instead of 10 cents, then the FTT would allow prices to be slightly further out of balance for a little longer, which has essentially zero consequence.
Another way to view these well-informed traders is that they profit by taking advantage of price shifts a short time ahead of ordinary investors. For example, a trader who has super-fast access to weather reports may be able to beat the market in movements of crop futures. This trader would capture some of the gain that otherwise would have gone to farmers or consumers. If an FTT makes this sort of trading less profitable, and thereby drives away some well- informed traders, it will be increasing the returns to other actors.
Meanwhile, in order to explain its inability to determine whether or not the net impact of the FTT on the economy in the long run would be positive or negative, CBO declares:
[T]he resources no longer used for financial transactions would be reallocated to other sectors of the U.S. economy and to other countries… Whether that reallocation of resources would lead to higher or lower GDP in the United States would depend on whether the new uses for the resources were more or less productive than the uses that would occur under current law, as well as on the degree to which trading moved abroad.
There is actually no question that the reallocated resources would be much more productively employed, because in the real world, the financial sector drains capital and labor (often highly-skilled labor) from productive uses elsewhere in the economy. Unless CBO can identify how the financial sector recently has increased the overall productivity of the economy, it should include some accounting for this drain and pick up the benefits to the real economy from reducing the drain. (See below for a discussion of trading moving abroad.)
Question #2: What impact would the tax have on municipal financing, including the cost to municipalities of funding their activities?
CBO’s response:
Like other entities that issue securities… municipalities would probably face slightly higher costs to finance their activities… [Since the] percent of the stock of outstanding municipal debt… traded on an average day… is low compared with the volume of trading for other types of securities… the tax would have a smaller impact on municipal funding than on trading in more liquid and active markets.
Again, this seems to be far from a smoking gun. CBO says that all issuers of securities would “probably face slightly higher costs,” and then specifies that municipalities will be the least affected among them. CBO then decides to opine on the FTT’s impact on state and local pension plans:
Besides initially reducing the value of their existing assets slightly, the tax would raise transaction costs for pension plans. Both of those effects would increase required contributions to the plans.
Earlier in the letter, CBO states the obvious point that the FTT would cause a decrease in the volume of trading. Most research suggests it would be reduced roughly in proportion to the increase in the cost per transaction. This means that if the tax were to double transaction costs, then trading volume would be reduced by about half. With fewer transactions to pay for, there would be very little to no effect on the total costs for investors, including pension plans. Also, at least some of the tax would be borne by banks in the form of lower fees. This means that trading fees are likely to remain roughly constant. If the revenue from the tax boosts growth, for example because it’s used for public investment, then this is likely to lead to higher asset values.
Question #3: What effect would the tax have on the depth and liquidity of the global market for U.S. Treasury securities?
CBO’s response:
Even after accounting for any reduction in borrowing costs from reducing budget deficits, the cost to the Treasury of issuing federal debt would probably increase in the short term because investors would pay less for Treasury securities that were less liquid. Over the longer term, whether that cost would be higher or lower than would otherwise be the case is unclear. Several factors, however, might reduce the tax’s impact on the liquidity of the market for Treasury securities and on the Treasury’s borrowing costs.
CBO does not explain how it calculates that in the short term the reduction in borrowing costs would be less than the increase in costs due to lower liquidity. Certainly a case could be made in the other direction, and CBO implicitly recognizes that by again inserting the qualifier, “probably,” in its assessment. It admits that it does not know the long-term impact, and then lists four reasons that the FTT’s effects on liquidity may be even weaker, but does not indicate how those factors may affect its original calculations on the short-term effects of the tax.
Even before answering any of Senator Hatch’s questions, CBO provides this opinion:
The tax would also decrease the volume of transactions and would make some types of trading activity—such as derivatives transactions to manage risk and computer-assisted high-frequency trading—unprofitable… Because of economies of scale in trading markets, as foreign holders of U.S. securities moved their transactions abroad, more of the market could go with them, which could diminish the importance of the United States as a major global financial market. That effect would be mitigated if other financial centers introduced their own transaction taxes.
CBO admits that high-frequency speculative trading can destabilize markets and lead to “disruptive events,” so making such trading activity unprofitable does not appear to be a strong critique. And CBO fails to mention that at least 29 countries – including Australia, Brazil, Hong Kong, Singapore, Switzerland and the United Kingdom – already have some form of the FTT, and that much of Europe is quite likely to adopt a higher-rate FTT in the coming year.
John Carney of CNBC, an admitted opponent of all new taxes – including the FTT – summarizes:
[A]s it turns out, Europe is considering a much higher financial transaction tax. So trades might actually migrate toward the US, since we’d be relatively tax-advantaged.
[R]educing high frequency trading is one of the goals of the tax, so this is hardly a strike against it.
[T]his CBO letter seems to be much less of a blow to the tax than headlines might lead you to believe.
