Hitting The Wrong Target: Why A “Wall Street” Transaction Tax Will Hit Main Street Investors And Miss The Mark on Other Fronts
In December of 2009, two proposals for taxes on the purchase and sale of securities in U.S. financial markets were introduced in Congress, one by Rep. DeFazio and the other by Sen. Harkin. Supporters of these securities transaction taxes (“STTs”) assert that they are appropriate and necessary for five reasons:
1. An STT will improve market efficiency by raising the costs of engaging in short-term, so-called “speculative” trading, thereby reducing market volatility;
2. Large Wall Street trading desks, and not Main Street investors, will bear the brunt of the tax’s burden;
3. An STT would not drive securities transactions away from U.S. markets to foreign locations;
4. An STT will “punish” Wall Street for its role in creating the financial crisis that has led to the recent recession; and
5. An STT will generate $150 billion in revenue annually, money which clearly would be welcome at a time of extraordinarily large budget deficits.
Each of these claims lacks merit. The DeFazio/Harkin proposals would reduce market efficiency, widen “bid-ask” spreads, drive trading to other markets, generate far less tax revenue than supporters assert, and cost average investors (in depreciated stock values alone) a conservative estimate of at least $138 billion. Mutual fund investors would bear additional costs of at least $260 billion over a 20-year investment horizon. Rather than punishing Wall Street for its undeniable sins that contributed to the financial crisis and justifiably angered the American people, the DeFazio/Harkin proposals amount to a direct hit on Main Street investors, at the very least the half of all American households that have stock investments. Moreover, the two proposals would generate far less than the $150 billion in revenue their proponents claim — no more than $60-$80 billion per year, and conceivably much less.
STTs have been the subject of debate in the academic literature since the late 1980s, and several countries with significant activities in securities trading have experimented with or implemented STTs to varying degrees. As a result, there is ample theoretical and empirical evidence available for evaluating the claims made by supporters of the DeFazio and Harkin bills.
A fair reading of this evidence indicates that the DeFazio/Harkin proposals would fail to achieve their primary goal of reducing market volatility attributed to “speculation” without harming individual investors. By increasing the costs of securities transactions, STTs reduce overall trading volumes, and therefore liquidity, thereby broadly decreasing asset prices. All investors, not just those paying the tax, would be affected. It is well established in the economic literature that the economic burdens of a tax frequently do not rest solely or even primarily with the entities that initially may pay it.3 Applied to an STT, “tax incidence theory” suggests that while the companies with trading desks will initially pay the tax, they will also pass much, and perhaps eventually all of it to both institutional and retail investors.
The DeFazio/Harkin proposals exempt purchases of mutual funds, inside or outside of retirement accounts, from the tax, and from this the bills’ authors argue that Main Street investors would not suffer. This is wrong. Because the investment vehicles that collect such funds would themselves be subject to the tax, they would pass much of it on to their individual customers in the form of higher service fees. Simply put, Main Street investors, not Wall Street traders, would bear a significant portion of the burden of any STT.4 Moreover, as demonstrated below, the harm to the average investor would be aggravated by additional indirect effects of an STT, notably the decline in asset prices and a reduction in overall trading volume.
Traders that face this tax could mitigate its effects by moving their trading, at the margin, to off-shore markets—an outcome that proponents of the STT have denied. In fact, however, STTs enacted in other countries have tended to decrease market efficiency, to generate less revenue than was anticipated, and to induce trading to move to foreign exchanges. It is therefore unsurprising that STTs have often been repealed once their negative effects on the economy have been revealed.
The notion that a transactions tax is justified as a way either to recoup losses that Wall Street imposed on the country through the financial crisis and subsequent recession, or that the tax is an appropriate means of punishing Wall Street for its sins, is also misguided. The financial crisis had many causes, but short-term trading was not one of them. Subprime mortgages, the proximate cause of the crisis, were marketed primarily by non-depository lenders. To be sure, the securitization of those mortgages was accomplished by many firms bearing the Wall Street moniker, but was also aided by ratings agencies and also by Fannie Mae and Freddie Mac, the government-sponsored housing enterprises that purchased the toxic securities. But neither the ratings agencies nor Fannie nor Freddie would be subjected to the proposed tax. Furthermore, although Wall Street commercial and investment banks engaged in excessive leverage, which magnified the financial and economic impact of the subprime mortgage crisis, these leveraged positions and the creation of mortgages backed by subprime mortgages had nothing to do with short-term trading, the object of the proposed transactions tax. Hence, proponents’ characterization of the tax as a legitimate method of recouping past losses or punishing Wall Street is erroneous. The activity that the tax targets – short-term trading -- was unrelated to the recent financial crisis and ensuing recession.