February 26, 2016
Are rivers flowing upstream? Has anyone seen four horsemen? Anyhow, it seems that the Washington Post editorial board is now acknowledging that a financial transactions tax [FTT] could be a serious policy. It ran an editorial which included a few derisive comments directed towards Senator Bernie Sanders, who has advocated a financial transactions tax in his presidential campaign, but favorably cited the Tax Policy Center’s analysis and said:
“They [FTTs] represent a ‘tempting’ option that might help the United States raise revenue while curbing speculative excess.”
There are a few points worth adding to the Post’s comments. The Post told readers:
“However, a tax would undoubtedly dampen some productive trading and not necessarily raise that much revenue, the report found — about $50 billion a year, in contrast to the $75 billion figure Mr. Sanders floats.”
As far as the concern for productive trading, the way the tax would reduce this is by raising the cost of trades. However, the cost of trading has fallen sharply over the last four decades. This means that the tax would, depending on the exact rate, only raise the cost of trading part of the way back to where it was four decades ago.
If the tax were set at a 0.1 percent rate on stock, with lower rates for other assets, then it would be raising the cost of trading to the levels of 10–20 years ago. So unless we see much more productive trading in the markets today than we did in the 1990s, we wouldn’t have much to worry about in this respect.
As far as the amount of money that would be raised, this depends hugely on the sensitivity of trading volume to the size of the tax. The Tax Policy Center assumed an elasticity of 1.5, meaning that the percentage drop in trading volume would be 1.5 times the percentage increase in trading costs associated with the tax. This elasticity assumption is certainly at the high end of the estimates in the literature. An elasticity assumption closer to 1.0, which is more in the center of the estimates in the research, implies the tax would raise roughly twice as much revenue.
It is also is worth noting that the 1.5 elasticity assumption used by the Tax Policy Center implies that trading volume decreases by a larger percentage than the increase in costs due to the tax. It would mean, for example, that if the tax raised trading costs by 40 percent, then trading volume would decline by close to 60 percent.
This means investors would reduce their trading by a larger amount than their costs per trade increased. As a result, investors would on average spend less money on trading, even including the tax, than they did before the tax was put in place. In that scenario, the entire burden of the tax is borne by the financial industry in the form of lost trading revenue.
Arguably the 1.5 elasticity assumption by the Tax Policy Center is too high, but if it is correct, it does mean the tax will raise less revenue, but it also means a much larger hit to the financial industry. Insofar as a purpose of the tax is to reduce the amount of resources being wasted by shuffling stock and derivatives back and forth all day, an FTT would have a huge effect in this case.