With Transaction Tax Becoming A Distinct Possibility, Does It Bring Benefits To The Table?

Even with a thoroughly discredited Tim Geithner repeatedly saying that a transaction tax is the worst thing since, well TurboTax, the topic is generating more and more traction, and earlier House Democrat leader Steny Hoyer noted that the topic is now a discussion item "on the table". With fervent voices on both side of the table, we would like to present the following paper by Dean Baker highlighting the benefits of a financial transaction tax.

Among the key points:

Taxation generally leads to economic distortions, with the possible exception of cases where the activity being taxed is itself harmful, such as smoking or drinking alcohol. While there are undoubtedly distortions associated with financial transactions taxes (it will have some impact on the cost of capital), much of the economic activity that will be lost as a result of the tax has the character of gambling. It will have very little effect on the effectiveness of capital markets.


In this sense, a financial transactions tax can actually increase the efficiency of financial markets. If the sector can just as effectively fill its function as an intermediary while employing fewer workers and requiring less capital, then the tax will have increased the efficiency of the financial sector. In this respect, it is worth noting the explosive growth of the financial sector over the last three decades. In the years from 1977 to 2007, the share of private sector wages in the narrowly defined securities and investment sector grew from less than 0.6 percent to more than 2.3 percent.


There is a real economic benefit to this growth insofar as it improved the allocation of capital, allowing firms to better gain access to capital markets or for individuals to better adjust their saving and spending patterns over their lifetimes. However, if this growth in resource use was only associated with additional trading and did not actually lead to better allocations of capital, then the resources were wasted. If a financial transactions tax reduces the volume of trading, and therefore the resources used by this sector, without harming the sector’s ability to allocate capital, then it will be making the sector more efficient and freeing up resources for more productive uses.

This could potentially be a very large benefit from an FTT. If it reduced trading volume by 25 percent (the middle scenario in Pollin et al.), leading to a corresponding reduction in resource use, it would free up more than $60 billion a year in labor and capital for productive uses. Whether or not reduced trading leads to serious harm to financial markets would depend on its impact on liquidity and market volatility. Obviously the tax will reduce liquidity by reducing the volume of trading, but it is not clear that the impact will have much consequence. For example, if trading of the most liquid assets, like government bonds, were cut by 50 percent, or even 75 percent, these assets would still have enormous markets. Such reductions in trading may reduce the volume to levels of 20-25 years ago, but these markets were already highly liquid in the 80s.

With empty federal tax coffers screaming, and the only industry reaping massive benefits courtesy of the government's largess, we believe a FTT will get more and more proponents as democrats and republicans alike realize that the tax revenue to fill the budget deficit is just not there, and relying on China to fund endless future deficits is simply too big of a risk.

The one clear benefit, from our perspective, that would accompany a Tobin tax, in whatever version it is ultimately implemented, would be elimination of such clearly market adverse phenomena as predatory algos and other HFT aberrations that have made trading even in the most liquid of stocks expensive, as we will shortly demonstrate, despite HFT proponents claiming the opposite.

Full Dean Baker paper below.