By the Editor
No one likes paying taxes, but we should never underestimate the appeal of cooking up new taxes for other people to pay, especially if a narrative can be constructed about how those other people are behaving badly. This is part of the reason we keep hearing proposals for financial transaction taxes. Many of the candidates who ran to be the Democrat nominee came out in favor of transactions taxes, including Sanders, Warren, Biden, Bloomberg, Buttigieg and Gabbard. One of the most detailed proposals came from Bernie Sanders who proposed a financial transaction tax as the source of funds to finance his proposal for student loan forgiveness. Setting aside the pros and cons of Mr. Sanders’ student loan proposal, is a financial transaction tax good policy? And is the proposal supported by a sound rationale?
Mr. Sanders estimated that his proposal would cancel approximately $1.6 trillion in student loans. To pay for this, Sanders proposed a financial transaction tax of 0.5% tax on stock transactions, a 0.1% tax on bond trades, and a 0.005% tax on derivatives transactions. Over ten years, Mr. Sanders estimated this tax would bring in approximately $2.4 trillion.
Why stick securities traders with the bill? According to Sanders, there are two reasons. First, a good portion of trading is “short-term” or “speculative” and therefore somehow bad. Second, the banking industry received a bailout after the financial crisis so now it is Wall Street’s turn to help out struggling Americans.
But are these reasons logical or even correct?
Underlying many proposals for financial transaction taxes is the view that trading, especially “short-term” trading, is somehow evil or at least of no fundamental value. Often short-term trading is labelled as “speculation” to create a negative connotation. For example, on his website Mr. Sanders proposes to “restrict rapid-fire financial speculation with a financial transactions tax.” This belief is misguided for several reasons.
There is nothing inherently good or bad about a securities trade as a result of the length of time an investor holds an asset. The price for any financial instrument is anchored by the intrinsic value of the asset, basically an estimate of all its future cash flows discounted back to today’s dollars. For a stock, this is an estimate of the future earnings of the underlying company. Traders often consider additional technical factors such as moving price averages, short interest, trading volume, and market momentum. However, the life-time earnings potential of a stock or bond will ultimately be the most important input to determine its price, even for investors who hold that stock or bond for a very short period of time. Therefore, it is misleading to conflate “short-term” trading with “short-termism”. Given these factors, it makes no sense to use taxes to punish market makers and short-term traders. In fact, chasing them out of markets will ultimately reduce the efficiency of the markets and harm other long-term investors.
What about the bank bailouts after the financial crisis? Doesn’t this make “Wall Street” a deserving target for this tax? Mr. Sanders promotes this view when he says, “During the financial crisis, Wall Street received the largest taxpayer bailout in American history. Now it is Wall Street’s turn to help rebuild the middle class.” This story doesn’t really hold up. All of the bailout money extended to the banks was fully repaid, with interest. And some of the institutions that trade securities today didn’t receive bailout money at all.
The effort to paint the banks as bad actors who deserve to be stuck with the bill is really just a diversionary tactic. The cost of transaction taxes would not really be borne by the banks or trading institutions. Instead, these costs would be passed on to end users, such as individual investors, pension funds, and holders of 401(k)s. Under the Sanders’ proposal to add a tax of 0.5% to stock trades, a retail investor making a modest stock trade of $10,000 would end up bearing an additional cost of $50 — a meaningful amount for a small investor working to build a retirement nest egg. Implementing a financial transaction tax would also require the addition of a new bureaucracy and impose increased compliance costs on the financial sector, creating wasteful friction in the economy.
Attempts to implement financial transaction taxes can be expected to encounter several challenges. Investors may seek to move their trading to other jurisdictions not subject to the tax, thereby lowering the proceeds from the tax below current estimates. Such a loss of trading activity would reduce liquidity in our markets, resulting in less efficient price discovery — something that would harm all investors. Also, traders can use alternative strategies to accomplish their trading objectives. For example, traders can use equity derivatives to gain exposure to certain equities instead of trading in the equity securities directly. Such strategies can be especially attractive when derivatives and the underlying instruments are taxed at different rates (as in the Sanders’ proposal).
These are some of the reasons that previous attempts to implement financial transaction taxes have had disappointing results. For example, a financial transaction tax was implemented in Sweden in the 1980s. Tax revenue fell far short of expectations and trading volume declined significantly as investors fled to other securities exchanges. After several years, the transaction tax in Sweden was deemed a failure and repealed.
The proposal from Mr. Sanders is based on a false narrative of extracting money from evil banks that unfairly benefitted from a bailout. But the reality is quite different. All the bailout money extended to banks has been repaid with interest. And the cost of a financial transaction tax will simply be passed on to investors, including pension funds, small investors, and holders of 401(k)s. More fundamentally, there is nothing inherently bad about trading financial instruments, even on a short-term basis. On the contrary, trading of all kinds is based on long-term value expectations and adds to healthy price discovery and liquidity. Upon examination, the facts don’t fit Mr. Sanders’ narrative, but the truth is not really the point. The point is to paint a picture where the victims paying the tax are somehow bad actors who deserve to be punished. Instead of trying to camouflage the true cost of taxes in this way, we should focus on making taxes as transparent, efficient, and fair as possible.
The Editor, Dec. 10, 2019