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Financial Transactions Tax Would Lower Incomes and Lose Revenue

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Financial Transactions Tax Would Lower Incomes and Lose Revenue

November 8, 2015

As Congress looks for ways to close the budget deficit, and Democratic presidential candidates search for ways to finance proposed new government programs, one option keeps coming up: imposing a financial transactions tax (FTT). This misguided idea has populist appeal as a way to make Wall Street pay their “fair share” of taxes, but it would slow the economy, resulting in lower tax revenue.

An FTT is a small (generally less than half of one percent) tax on purchases of financial instruments. Say the government imposed an FTT of 0.5 percent, as Senator Bernie Sanders has proposed. If you buy a stock for $100, you would have to pay fifty cents in tax. Sanders wants to use the tax to finance free tuition at public universities, and it is also a major component of the financing plan for a Medicare-for-all program proposed by House Democrats.

In addition to the government revenue it would generate, proponents see the FTT as a way to reduce market volatility. High-frequency traders who move trillions of dollars through the financial system would get hit hard by even a small FTT. This, in proponents’ eyes, would stabilize markets by disincentivizing high-frequency trading.

But these dual objectives of the FTT represent a sort of doublethink. In order to reduce high-frequency trading, the FTT would have to reduce trading volume. (High-frequency trading comprises up to 84 percent of financial transactions.) But putting a significant dent in high-frequency trading would also reduce the FTT’s revenues. Fewer trades mean fewer taxes.

Despite this, the Medicare-for-all financing plan assumes no reduction in trading volume, and Sanders claims his FTT for free college would raise “hundreds of billions” of dollars annually. Progressives are assuming two contradictory outcomes for the FTT—it simultaneously reduces economic activity, and doesn’t!

Unfortunately for progressives, it appears that the FTT may not accomplish either of these objectives. According to a literature review by IMF scholar Thornton Matheson, financial transactions taxes do not necessarily reduce market volatility. Since FTTs represent transactions costs, they reduce liquidity and make it more difficult for asset prices to settle on their true values. According to empirical evidence, this effect more than cancels out the activity of irresponsible “noise traders” which increases volatility.

Moreover, the reduction in trading volume is not the only effect of the FTT. While in the short run traders would absorb the costs of the FTT, and the government would pocket extra revenue, in the long run it would raise the cost of capital, a burden that would ultimately be passed on to businesses and workers. 

An Institute of Economic Affairs report by Tim Worstall finds that a 0.1 percent FTT would lower long-run GDP by 1.8 percent. This results in lower incomes for workers and lower revenues for businesses—meaning less revenue for the government from income and corporate taxes. According to Worstall, it is more than likely that an FTT would lose money.

The risks of implementing an FTT—higher volatility and lower economic activity—are too great compared to the improbable benefits. It is a gamble policymakers should not take.

 

Preston Cooper is a Policy Analyst at Economics21. You can follow him on Twitter here.

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