WASHINGTON - As policymakers in the U.S. and Europe contemplate mechanisms to ward off another economic near-collapse, one idea is gaining traction among liberals at the same time as it is infuriating conservatives: a financial transactions tax.
Democratic lawmakers and other advocates are pressing for the creation of a sales tax applied to stocks, derivatives and other financial instruments. The idea has been around for decades. In fact, there was just such a tax in the United States from 1914 to 1966. The U.K. raises more than $30 billion a year on a tax that applies only to stocks.
Backers of financial transaction tax -- including labor unions and liberal groups -- argue that even with the major decline in stock and derivatives transactions stemming from the tax -- some estimate as much as a 50% decline in volume of trades -- such a fee could raise more than $100 billion a year to fight the deficit, create jobs or other purposes.
Proponents of the tax also argue it would dampen financial speculation and hyper-trading would diminish, which they say contributed to the bubble that led, in part, to the crisis in 2008.
Opponents of the tax contend that it will increase the volatility of stock prices, reduce liquidity and efficiency of the financial markets, and at the same time raise the cost of transactions for long-term "average Joe" investors directly -- or indirectly, through their retirement savings funds.
Critics argue that the kind of trading the tax would eliminate -- mostly a form of high-frequency trading that by some estimates represents 70% of all the trades on an average day -- did not cause the financial crisis. Securities groups contend that the tax could undermine the tentative economic recovery underway and stifle job creation.
White House not sold on the idea
Rep. Peter DeFazio, D-Ore., introduced a financial transaction tax in December, which would impose a 0.25% fee on stock transactions. Derivatives swaps would be taxed at a rate of 0.02%, based on the bill, which has 27 supporters in the House. Sen. Tom Harkin, D- Iowa, is working on legislation in the Senate that would tax stock transactions to generate revenues to help reduce the deficit.
"We need something to damp down speculation and raise revenues," DeFazio said.
Nevertheless, Treasury Secretary Timothy Geithner says the Obama administration isn't on board with the efforts. Rather than back a transaction tax, the White House proposes taxing financial institutions with $50 billion or more in assets to cover the remaining cost of a financial rescue package.
In addition to Geithner, former Federal Reserve Chairman Paul Volcker, who is an advisor to Obama, has expressed reservations about it.
Nevertheless advocates are organizing events on Capitol Hill, seeking to generate support for the measure. Dean Baker, co-director of the Center for Economic and Policy Research in Washington, argues that a transaction tax would result in a major decline in the volume of trading, which he says would be a good thing because it could reduce volatility, increase efficiency and dampen the kind of speculation bubble and busts that led to the recent financial crisis.
"It may lead to situations that are less prone to the sort of speculative run-ups that we have seen in markets in recent years," Baker told participants at an event organized by Public Citizen.
Baker argues that the financial industry is akin to the trucking business in that it is an intermediary that brings goods -- in this case investments -- from point A to point B. However, he points out that, unlike the trucking industry, the financial industry has exploded over the past three decades relative to the size of the economy and is now five times as large as in the 1970s.
"Are we more secure in our savings? Do we think capital has been allocated better? It's hard to argue that that is the case," Baker said. "Why would we want more people employed in trucking if they are not better able to bring goods from point A to point B? If we reduce the volume of trading, without impeding the financial sector in securing our savings, allocating capital, that's a benefit for the economy."
High-frequency trading has its place
However, Georgetown University Professor James Angel argues that high-frequency investors would be discouraged from conducting trades if a financial transaction tax were imposed, raising investor costs. He argues that these traders improve market efficiency and reduce costs for all investors by slicing away the spread price between what a buyer is willing to pay and a seller is willing to sell for.
"The bid-ask spread is a major transaction cost that has gone down significantly, in part, because of high-frequency traders and that helps all investors," Angel said.
The removal of high-frequency traders from the markets would lead to small differences in prices, known as mispricings, of stocks trading on different exchanges, he added, as well as distorting the price of exchange-traded funds.
"You would see a lot more noise in the markets," Angel said.
A transaction tax, he argues would have a negative impact on the markets because these arbitrageurs take advantage of mispricings, between different markets and stock exchanges, leading to corrections in prices. For example, a high-frequency trader who sees the same stock trade on different exchanges -- a corporation's ordinary stock in the U.K. and its American Depository Receipt, or ADR, in the U.S -- at different prices will make investments that ultimately bring the prices in line with each other.
"That linkage between a stock in the U.S. and the U.K. makes it possible for U.S. investors to diversify their portfolio globally," Angel said. "It allows you to trade something that looks like a U.S. stock in the U.S. hours for a company that might be housed in a different country, with a different language."
With even a small transaction tax, these high-frequency traders would lose their incentive to trade, in part, because the pennies they earn on a trade would be offset by the tax.
Pension fund investors
DeFazio's bill -- on its face-- would exempt pension funds, mutual funds, education and health savings accounts. It also exempts the first $100,000 of annual transactions, as a means of helping out smaller investors.
However, Georgetown's Angel argues that the average pension fund would not be free from the impact of a transaction tax even with exemptions for pension fund investors in the bill.
That's because mutual fund managers buying and selling stock on behalf of pensioners would pay the tax, plus suffer from wider bid-ask spreads, Georgetown's Angel points out.
International cooperation?
Most observers of the proposed tax contend that it would likely need to be proposed jointly by a number of countries. Baker points out that France, Germany and other European countries have expressed an interest in their own financial transaction tax.
"There seems little doubt that if the United States pushed for such taxes at the G-20 or other international forums that it could count on considerable cooperation from other countries," Baker said.
© 2010 Dow Jones & Company, Inc.
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