A Transaction Tax on Financial Transactions?

The Wall Street Journal has a new story from over the weekend on Democratic proposals, in Congress and the administration and from outside groups, to impose a tax on financial transactions (John D. McKinnon, Democrats Weigh Tax on Financial Transactions, WSJ, October 10, 2009):

Taxing financial transactions on Wall Street is gathering support in high places.

With federal budget deficits soaring, policy makers and other advocates are eyeing the huge sums that could be raised as a way to cover the costs of new initiatives.

Labor unions, in particular the AFL-CIO, have proposed a financial-transactions tax as a way to defray costs of a health-care overhaul. Lawmakers have discussed a similar fee as a way to cover the cost of future financial oversight. Liberal advocates are pushing the tax to pay for new stimulus spending.

Financial transactions taxes, whether on the US domestic level or the often-proposed international “Tobin tax,” are sometimes described simply as broad based revenue raisers, and sometimes described as ways of deliberately slowing down the movement and flow of capital.  As a revenue raiser, one current proposal operates this way:

This week, the left-leaning Economic Policy Institute floated the idea of a national transaction tax that would raise $100 billion to $150 billion a year. The tax, at a rate of 0.1% to 0.25% of the value of the trade, would be levied on all financial transactions such as stock trades, but not on consumer transactions such as with credit cards.

The money would be used initially to pay for temporary aid to states, hiring incentives for public- and private-sector employers and school construction money.

“We are in a difficult time right now, so people are looking at every opportunity to gain some revenue to fund” new initiatives, said Rep. Stephen Lynch (D., Mass.), a member of the House Financial Services Committee. “Because I was one of the first to suggest using this to fund [new] regulatory infrastructure, folks have come to me and said, ‘That’s a good idea; I’ve got a better one: Why don’t we use it for stimulus or especially health care?'”

One Democratic aide said the idea is under consideration among House leadership, though the discussions are preliminary.

It does sound like a dandy, relatively hidden revenue raiser – one that could generate vast sums of money relatively unnoticed, at least among ultimate ordinary consumers and taxpayers, who will not notice the long-term, collective hit to their pension funds and retirement funds which, anyway, they often do not directly manage.  However, taxing at the front end is generally considered more distorting than taxing at the back end, and a tax on simply engaging in transactions themselves is almost certainly more distorting, other things being equal, than a tax on the final net economic transaction.  Certainly less transparent to those who ultimately bear the tax.  And of course there are many questions of where the incidence of tax falls – after all, a huge percentage of these transactions involve people’s retirement funds, long term savings, pension plans, including those of the unions.  It is not just a bunch of plutocrats sitting around trading their stocks and bonds.

Hence a bit of bait and switch – when that point is raised, then the defense is offered that, well, after all, it is independently a good thing to slow down and make more expensive capital market transactions.  Capital flows too quickly and too fluidly as is, on this view; it needs to be slowed down, for its own sake, quite apart from the revenue raising.  The sand in the wheels of commerce is a good thing because the flow of funds is, if not precisely too efficient, then too volatile.  This was an argument heard particularly in the 1990s with respect to the global capital markets, around the various currency crises, the Mexican peso crisis of the early 1990s or the Asian crisis of the later 90s.  Of course, another bit of bait and switch was going on in those arguments as well – many of the Tobin tax supporters presented this as a desirable distortion of incentives, but actually were interested in the revenue, proposed as a way of funding international organizations starting with the UN.

Sometimes the transactions tax is coupled with the idea of exempting transactions that favor holding for some period of time – an anti-volatility, anti-rapid-turnover kind of rule; sometimes it is suggested that this will spare long-term retirement savings from the burden of the tax.  The problem is that the distortionary effects are not easily separated that way; the effects of economic distortion are not the same as the question of who pays the direct transaction tax.  The economic distortions are far less about whether I pay such taxes on my relatively infrequent trades in my retirement account and much more about whether the market as a whole is less efficient and so reduces the long run growth and value of my retirement account indirectly, irrespective of whether I, individually and directly, pay much in the way of the transactions taxes.

According to the article, leading Democrats such as Barney Frank are open to the idea.  The revenue needs, it seems, will be insatiable, and the distortions something like the indirect, hard to pin down, long-run effects of inflation.  But in the case of a domestic US transactions tax, of course there is something else to worry about.  There is no reason why financial transactions have to remain in American markets.  Other than efficiency, liquidity, depth, interconnectedness among financial markets, security, relatively good corporate and regulatory governance, transparency, low transaction costs, the neutral application of the rule of law to all comers.  Yes, the United States offers all those things, but it does not have a monopoly of them, obviously.  London offers all of that.  So do other places – mainland China does not, as yet, but Singapore does, and other places in the world.

Hard as it might be to imagine financial market transactions migrating from the US elsewhere, it has happened to many financial centers in the past and can happen to the US in the future.  The US has huge accumulated advantages in these areas, many of which are social, institutional, and political-legal cultural benefits that seem immutable and free-standing.   On the other hand, automotive Detroit seemed immutable and free-standing and the beneficiary of all those advantages for decades and decades – its political class decided to eat its seed corn, so to speak, and even once it was obvious where it was heading, decided to go with the flow and double-down the bet on ‘other taxpayers’ money’.  Maybe it will (continue to) work out for the best for the UAW and its labor allies, at the expense of the rest, but there are limits to even what the current administration can do for it.

This is not a declinist prediction.  It doesn’t have to be this way.  It is, rather, to observe that for the US now, actions to promote US decline are decisions taken today by the political class.  Decline-inducing decisions include making the US less attractive as a capital market center and leader, making transactions more expensive in order to favor current spending.

Does a complex welfare state need taxes?  Sure.  Transparent, widely shared, everybody pays something and everyone can see what they pay, so that everyone has a stake in the extent of taxing and spending, as visible and little distortionary as possible.  Thus almost the opposite direction to where the US tax code has drifted since the 1986 reform and even more so to where current proposals aim to go.  They tend to increase the rent-seeking possibilities of the political class and its ability to ‘get the juice’ from economic actors who must navigate the artificial shoals of regulations that aim to benefit particular constituencies and particular politicians.  VAT taxes flunk the transparency requirement, as do turnover taxes of this kind.  That is, of course, one reason why politicians love them.

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