The new round of proposals for a tax on a wide array of financial transactions

There is little new in this round of discussion of a new financial transactions tax (FFT). One exception is that some prominent European leaders have expressed support for it. Although the agreement is broad brush and does not contain important details. Another is that relatively more of the discussion is focuses on the notion of a very small tax rate of 0.01% to 0.0005% in contrast to the 0.50% to 0.10% of a few years ago. Nonetheless the claims of many proponents remain very grand, with annual revenues between $200 and $300 billion – some reaching near $1 trillion – plus it will also have the power to stop speculation. While the SEC currently charges a fee on securities transactions, it is de minims. It was 0.00333% until Bush cut the tax in 2002, and it is now 0.00127% after falling to 0.00056% in parts of 2008 and 2009. OMB estimates that this and other SEC fees will raise $1.5 billion in FY2010. The CBO estimated that $0.25 tax per contract on exchange traded futures and options would raise $113 million. Together that raises $1.61 billion from a transaction tax base covers the majority of financial transactions in the US and at least a quarter of those globally. So in order to raise those big numbers the rate will need to rise and the base expand substantially.

There are several points that are flat wrong, and there are several aspects of these proposals that make them relatively inferior to other policies that would achieve the same intended goals.

The first thing that is wrong, and reflects widespread misunderstanding about financial markets, is that a FTT is a tax on liquidity, i.e. market trading volume, and not speculation. Liquidity can be very useful in making markets more stable. The current financial crisis, though sparked by a collapse in the value of mortgages, was caused in large part by the loss of trading liquidity (and funding liquidity) in financial markets. Taxing trading liquidity is not going to fix current problems or prevent future instability. Private label MBS and CDO were not the most liquid securities to begin with anyway. It was not their excess trading liquidity that led to the problem and so hampering future liquidity will not prevent another problem.

The second thing wrong is that the tax would fall most heavily on the very parts of the financial system that did not malfunction during the crisis – the exchange trading of stocks, futures and options. These exchanges, such as the NYSE and the CME, are where the trading volume is, and they did not fail or malfunction during the crisis. It is a bad policy to weaken the relatively stronger segments of the system and to relatively strengthen the weaker segments – namely the OTC markets – where the problems arose.

The third thing that is wrong with the policy proposal is that it would require a whole new tax administration. The SEC does have an extant system for collecting section 31 fees and that could be adopted for use by the IRS. The rest of the system would impose huge start up cost. Alternatively there are other existing taxes that should be considered (see below).

The forth thing wrong is that if the newer version of a very small rate is adopted, then it will not raise any substantial amount of revenue. And of course to that extent that it raises revenue there is no guarantee that it would be spent on development, mitigating climate change or other worthwhile goals.

There are also some things relatively inferior about the proposal. The first and foremost is that a higher capital gain tax rate would be a better make to discourage speculation or to mitigate any costly externalities from the activity by taxing it. Also, the new so-called Volcker tax on the non-deposit (and non-capital) liabilities of very large banks would also more directly tax risk taking through the use of repo and other such funding mechanisms that are used to increase on-balance sheet bank leverage.

The other major policy tool addressing the externalities of risk taking is to support better prudential regulation of all financial market activities. It does not raise revenue, but by helping prevent another crisis will avoid the destruction of the existing revenue base and the use of revenues to rescue undeserving financial elite.

Yet another better approach would be to tax executive compensation so as to incent intermediate to long-term investment goals by deferring the calculation and payment of bonus (non-base) compensation. What is the bigger social cost? Is it underpaying a few multi-millionaires or underpaying millions of poor and middle-income workers