A Financial Transaction Tax

The following is excerpted from a working paper, "A Financial Transaction Tax: Revenue Potential and Economic Impact." Read the whole paper here.

Keynes proposed it. Oxfam is circulating a petition world-wide to garner support. Gordon Brown has urged its implementation. Bob Herbert has urged it in the New York Times. James Tobin called for it. The IMF Working Group of 20 is soliciting comments on it. And Larry Summers (with his wife) wrote an article advocating it. What is “it?” – a financial transaction tax (FTT), a tax on all financial transactions. In its broadest and most effective form, an FTT would be levied on all trades in three financial asset markets: equity, interest rate (debt), and currencies as well as the derivatives that are priced off the underlying markets for each asset class.

An FTT has multiple appeals. First, the revenue that could be generated is significant in terms of both the absolute dollar amount and in the context of the financial needs of the U.S. government as it responds to the ongoing economic crisis. Second, and equally important, an FTT would impact relatively few individuals and institutions with benefits potentially flowing to many. Finally, the political logic of an FTT – the dynamics of Wall Street vs Main Street – makes the tax a timely one that should have significant appeal in today’s political climate. […]

For progressives, taxes are best levied when they meet two criteria: first, that they are progressive in impact and, second, that the tax discourages unproductive resource use and may even encourage a shift of resources to socially productive uses. A progressive tax raises disproportionately more revenue from those individuals or institutions that have more income and or wealth, while a tax that discourages unproductive resource use may encourage reallocation of resources such as labor and money to uses that are as or more productive as those to which the taxed individuals or institutions would otherwise apply them. An FTT meets both conditions.

The FTT is a Progressive Tax

A tax on the trading of financial assets will, obviously, be paid by those who trade such assets. Consider the most widely held of the three asset classes, equities and equity derivatives. While almost half of all households in the US own some stocks, the majority of these households own stocks indirectly, that is through a pooled investment of some type. This is commonly a mutual fund or a pension fund. The latter itself is usually invested in a series of mutual funds. Only slightly over 20% of US households own stock directly, and the bulk of this ownership is concentrated in a much smaller number of households. It is only among the top 10% of households by income that more than half report direct ownership of stocks. Only among this small group does the value of such holdings exceeds $20,000/household. Therefore a tax on trading activity will fall heavily on this affluent 10% of all households. Of course, even in this case, if a household follows a buy and hold strategy, they will pay very little tax.

Households that own stock indirectly will pay the tax indirectly to the extent that the portfolio managers who invest their savings engage in trading activity. These households can also exercise considerable control over the extent to which they pay the FTT by choosing funds that trade infrequently. Such funds also tend to be those that charge lower management fees, for example index funds that simply track a particular measure of the stock market such as the S&P 500. Since there is no evidence that increased trading by active managers out performs index funds (although it does generate increased revenue to the active managers), any shift by households into such funds will certainly not depress their long run returns. It will probably actually improve them. A significant shift of savings out of the hands of active managers and into the hands of index fund managers would likely reduce the compensation of the former and diminish the flow of individuals into these highly paid jobs. However, any concerns about a possible resulting diminution of investment choice are unfounded. Currently there are more mutual funds than individual stocks listed on the NYSE. We could experience a considerable decline in the number of the former without imperiling individual choice of investment vehicles.

Some may argue that reducing the potential returns to individuals choosing to enter the financial sector will result in fewer highly educated and intelligent young people choosing financial careers. However, there is no evidence that such a decrease would have a negative impact on either the markets or the larger economy. In fact, it can be plausibly argued that fewer MBAs going into finance and more bright young people entering education, medicine, or research careers would be a net positive impact of an FTT. The cost of carrying the financial sector suggests the desirability of reducing the portion of our economy accounted for, and the share of our economic resources devoted to, these activities.

Aside from the relatively small percentage of households who own a significant amount of equities and are also active traders, who else would pay an FTT levied on equity and equity derivatives? There are two other categories of individuals and institutional traders that would be expected to bear most of the taxation: day traders and institutions such as hedge funds, proprietary trading desks at broker-dealers, and a large number of nonfinancial corporations who have borrowed to engage in financial activities that were frequently unrelated to their core business.

The percentage of trading accounted for by day traders is undoubtedly down from the glory years of the late 1990s but, at least for NASDAQ listed stocks, it is still quite significant. I wish no particular ill to day traders – indeed I have engaged in such activity myself - but I also do not see any compelling reason to believe that a decline in their number would be detrimental to our economic well being. Stock markets survived and thrived for centuries without relying on people investing for returns of less than 0.5% (the round turn impact of the proposed FTT) and I am confident they will continue to do so. Day traders who seek larger returns will undoubtedly continue their activities although at somewhat reduced levels of profitability.

In sum, the household and individual impact of an FTT would fall primarily on the upper end of the income and wealth distribution in the U.S. The tax is therefore progressive in impact and could act to redistribute income towards less affluent households by means of social and economic programs financed by the revenue generated.

The FTT is a Socially Productive Tax

The question of institutions such as hedge funds and proprietary trading desks is more interesting and goes directly to the question of productive and unproductive use of resources. The unprecedented increase in equity trading over the past 30 years is not primarily the result of increased activity by that small percentage of households with significant equity holdings or the emergence of day trading. Instead it is the result of (i) a shift in focus and activity of broker-dealers away from their brokerage function and towards their dealer function and (ii) the rapid growth in proprietary trading activity by components of the shadow banking sector, especially investment bank trading desks and hedge funds.

The case of broker-dealers is instructive, both assessing the growth in equity and equity derivative trading and because of the larger process of financialization that it illuminates. In 1975 proprietary trading and associated revenue accounted for less than 25% of NYSE member firm broker-dealer revenues, while commission revenues were 46% of revenues. Although a minority of all broker-dealers, the NYSE members are the largest broker-dealers and account for the bulk of all broker-dealer activity and revenues. By 2000 the proportion of NYSE broker-dealer revenues accounted for by trading and associated revenue was over 56%, and commission revenues represented slightly under 14% of NYSE broker-dealer revenues.11 What was happening to NYSE member broker-dealers, and at other financial services firms, is a shift into trading and fee collection and a move away from the brokerage function. The increase in proprietary trading drove growth in stock trading, accounting for a significant portion daily stock market activity. Within the broker-dealer category, the proprietary trading desks of major firms such as Goldman Sachs and Morgan Stanley (and others such as Bear Sterns and Lehman Brothers before their collapse) have dramatically increased their market activity and share of total equity trading.

Broker-dealers, then, would be among the entities that would pay the FTT. To the extent these firms are simply skimming a few cents/share, e.g,. the flash trading that has been in the news lately, any loss of activity would be of no concern to other market participants since it would reduce trading that is of very questionable legality anyway and, again, activity without which stock markets survived and thrived for centuries. Other proprietary trading that seeks returns in excess of the 0.5% FTT should be only slightly affected. Further, as argued in the discussion of active and index portfolio managers, any diminution in the salaries of proprietary traders that reduces the flow of bright young people into these jobs is likely a plus for the economy as a whole. The arguments that apply to broker-dealers also apply to hedge funds and other participants in the shadow banking sector that have contributed to the growth in equity and equity derivative trading. The same arguments also apply to the non-financial corporations that have sharply increased their participation in financial markets over the past two decades. If the trading activities of these entities are driven by small margin trades with returns less than the 0.5% FTT, there will be less trading. However, any loss of this small profit margin (less than the FTT amount) trading is not a loss to the economic well being of the US economy or that of the vast majority of the US population.

The growth in proprietary trading activity among equity market participants is paralleled in the currency and debt markets. Currency trading has grown rapidly over the past several years. At the same time, however, as the market has gotten bigger it has also gotten narrower. Thus the number of banks that are major players has actually declined. For example, in the 1998 BIS survey, there were 20 US banks that accounted for 75% of currency trading in the US; in contrast, in 2007 a mere 10 banks accounted for 75% of US currency trading. The impact of an FTT would therefore be felt primarily by a few very large banks. If the result were a diminished role in the industry for a few very large – too big too fail? – banks, the outcome would again be a net benefit, helping the U.S. political economy return to a more balanced structure.

As in the case of equity trading, very little of the activity in the currency and currency derivative markets is related to commercial enterprise. The BIS reports that over 75% of currency trades executed in April 2007 had a time duration of less than one week. Further, the entities that represented the bulk of trading activity were not commercial enterprises engaged in the import and export of goods or services. Instead it is again hedge funds, mutual funds, pension funds and insurance companies that have been the drivers of growth in the currency and currency derivatives markets. “Technical” trading now dominates these markets, much as it does in equity markets. As a result, turnover in the currency markets is almost 25 times the actual value of international trade.

In sum, an FTT would not only be a progressive tax, it also has the potential to be socially beneficial. An effective FTT would generate a disproportionate share of revenue form affluent households, broker-dealers, large banks and participants in the shadow banking sector. These are precisely the entities that drove the U.S. and world economy close to total collapse in 2008 and that, absent far reaching reform, may do so again. In addition, an FTT is also a market driven tax, allowing the market to determine which trading activities should continue and which do meet some minimum test of profitability and should therefore cease. […]

[A]n FTT should be designed to apply to all classes or financial assets and to apply across the range of products traded in financial asset markets. Second, a financial transaction tax has the potential for raising a significant amount of revenue. Third, at current trading levels an FTT could generate as much as $1 trillion in revenue. Finally, equity and equity derivative trading, the most transparent markets and the easiest to tack, would generate the largest amount of revenue with spot currency and currency derivative markets the second largest source. Of course if trading were reduced because of such a tax, the revenue raising potential would also be reduced but would still appear to be significant.

An FTT is progressive in impact and would also have the potential to assist in restructuring the U.S. political economy away from an overdependence on finance and financial services. It is widely urged that such shift out of financial activities and a strengthening of manufacturing is a desirable goal but, to date, very little has been done along these lines.

Perhaps more important, however, is the political significance of an FTT. The tax could be cast in terms of Wall Street vs Main Street or it could be articulated as a matter of economic justice. In either case the financial sector would be called upon to return some of the assistance that was rendered to it during the melt down of 2008. This formulation would have immense political appeal and, I think, help the U.S. break out of the politics-as-usual gridlock into which we have drifted after the initial enthusiasm of the Obama election and the sense that the times were right for change. As the earlier reference to Gordon Brown and Alistair Darling of the UK suggests, I believe that the political appeal of a well structured FTT would also likely transcend national borders.

In urging an FTT progressives should, I believe, tie the revenues to programs and policies that distribute benefits widely and would be seen to be such. For example, a significant portion of FTT revenues could be earmarked for a jobs program designed not simply to recover the over 8 million jobs lost since December 2007 but to expand access to good jobs across the U.S. labor force. Revenues from an FTT tied to a jobs program* could also be the basis for an industrial policy that restructured the U.S. economy along the lines of sustained and sustainable growth that increases equality rather than inequality.20 The possibilities are visionary in scope. What we need now is the political will to move forward.

*For one example of such a jobs program, see “A Permanent Jobs Program for the U.S: Economic Restructuring to meet Human Needs,” at www.cpegonline.org.

Bill Barclay worked for 22 years in financial services before retiring in 2004. Since then he has been active in the Oak Park Coalition for Truth and Justice and Democratic Socialists of America.