Policy Documents

Research & Commentary: Transaction Taxes

Eli Lehrer –
December 14, 2009

In recent weeks the idea of a "transaction tax" that would impose an apparently small fee on all stock, future, swap, credit default swap, and option transactions has gained significant support among some members of Congress and left-of-center advocacy groups. Rep. Peter DeFazio (D-OR) and 25 other members of the House of Representatives have introduced the Let Wall Street Pay for the Restoration of Main Street Act (H.R. 4191). Sen. Tom Harkin (D-Iowa) plans to introduce a similar bill in the Senate.

The current House legislation would impose a tax of 25 cents per $100 on the total value of transactions involving a broad array of financial instruments. Half of the money raised through the tax--no official estimates exist, but proponents have suggested it would be in the hundreds of billions--would fund a "job creation reserve," and the other half would be used to reduce the federal budget deficit. (The latter provision, stated as a "sense of Congress," would be unenforceable without major changes in budget rules.) Even those who favor this type of tax, however, estimate it will produce less revenue than its congressional proponents think.

Proponents of the tax say it would have almost no effect on individual investors (who could claim a $250 per-person tax credit against it on federal returns and, in theory, avoid it altogether when trading in retirement accounts), would encourage long-term investing, and might even help some Wall Street firms by reducing market volatility. However, a broad spectrum of economists, financial analysts, and entrepreneurs has expressed opposition to the proposed tax, arguing it would impose enormous hidden costs on individual investors, fail to reduce volatility, and drive financial-sector jobs to other countries.

Opponents of a transaction tax also argue it would significantly impede the efficient allocation of capital by discouraging trading and thus slowing the rate at which money flows from failing ventures to those more likely to create new wealth. Through this reduction in the rate of capital flow, such a tax could prolong recessions and slow economic growth.

The following represents a broad cross-section of free-market opinion on transaction taxes.

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A Transaction Tax Would Hurt All Investors
http://online.wsj.com/article/SB20001424052748703558004574579903734883292.html
In this op-ed for The Wall Street Journal, Princeton University Professor Burton Malkiel and Vanguard Group Chief Investment Officer George Sauer argue that individual investors--not the high-frequency traders wrongly referred to as "speculators"--would end up paying the great bulk of the costs related to a transaction tax. They further contend such a tax would be almost impossible to enforce and could easily cause a massive flight of capital from U.S. markets.

A Tax on Financial Transactions: Good or Bad Idea?
http://aswathdamodaran.blogspot.com/2009/11/tax-on-financial-transactions-good-or.html
Writing in his widely read blog, New York University finance professor Aswath Damodran considers the pluses and minuses of a transaction tax and comes out strongly against it. Damodran argues the rationale for the tax is internally inconsistent, that it would likely fail to raise the promised revenues, and that it would hurt markets overall.

Transaction Tax and Stock Market Behavior: Evidence from an Emerging Market
http://www.springerlink.com/content/d721857t410764nh/
Badi H. Baltagi of Syracuse University and two coauthors examine the ways a transaction tax similar to the one being proposed might work in the United States, in this paper from the academic journal Empirical Economics. Based on a complex model of two Chinese stock exchanges that imposed transaction taxes, the research team finds these taxes actually increase the speculative volatility they are intended to decrease, while simultaneously reducing the efficiency of the market.

The Effects of the Stock Transaction Tax on the Stock Market -- Experiences from Asian Markets
http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VFF-3V72TM1-R&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&_docanchor=&view=c&_searchStrId=1129847757&_rerunOrigin=scholar.google&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=9d490719ae535e5d5d8762c86bf9360d
In this paper from the Pacific Basin Finance Journal, Shing-Yang Hu, a professor at National Taiwan University, performs a comprehensive analysis of transaction tax changes in the largest Asian stock markets (all of which impose transaction taxes). Hu finds the taxes reduce average stock prices but do not reduce market volatility.

Securities Transaction Taxes: An Overview of Costs, Benefits, and Unresolved Questions
http://www.jstor.org/pss/4479680
Writing for Financial Analysis Journal, G. William Schwert of the University of Rochester and Paul Seguin of the University of Michigan offer a broad overview of many of the questions raised by previous U.S. proposals for financial transactions taxes. The two find the imposition of any such broad financial transaction tax implies many risks--including the loss of financial-sector jobs and distortions in investment decisions--and that some of the expected benefits may not be realized. They conclude that such taxes create very significant market distortions.

Transaction Taxes and Stock Market Volatility
http://ideas.repec.org/p/hhs/hastef/0025.html
In an entry in the Stockholm School of Economics' Working Papers Series, Stockholm professor Ragnar Lindgren performs a very broad analysis of all the major stock markets that imposed transaction taxes over an 11-year period. He finds that for the most part such taxes do not have the volatility-reducing effects their proponents contend they have. In some cases, in fact, Lindgren finds higher transaction tax rates may increase price volatility of financial instruments.

When Financial Markets Work Too Well: A Cautious Case for a Securities Transaction Tax
http://www.springerlink.com/content/p016371m624r6742/
In this 1989 paper for The Journal of Financial Services Research, current White House economic advisor and former U.S. Treasury Secretary Lawrence Summers and his then-wife Victoria (a tax attorney) offer a "cautious" and well-argued case for a transaction tax on securities. They review the literature and explain how a tax could work. The two estimate, however, that such a tax--set at twice the rate proposed in the legislation and without any credits--would produce only $10 billion in revenue (about $17 billion 2009 dollars). That is far less than the hundreds of billions of dollars the tax's proponents claim it might generate.

Securities Transaction Tax and Market Efficiency: Evidence from the Japanese Experience
http://www.springerlink.com/content/t54w7117n3n43500/
Writing for The Journal of Financial Services Research, Shinhua Liu of Texas A&M University examines the consequences of changes in rates of the Japanese transaction tax through a model comparing the performance of Japanese stocks to that of American Depository Receipts (ADRs), which represent shares in those stocks. (Japan has a transaction tax, and the United States does not.) Liu finds the higher transaction costs resulting from the tax undermine the efficiency of the "price discovery process" for stocks in the Japanese market.

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Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit The Heartland Institute's Web site at http://www.heartland.org and PolicyBot, Heartland's free online research database.

If you have any questions about this issue or The Heartland Institute, you may contact Eli Lehrer, director of The Heartland Institute's Center on Risk, Regulation, and Markets, at elehrer@heartland.org (202) 615-0586.