Throwing Sand in the Wheels of the Market

According to a report from the New York Times , a financial transaction tax–which would impose a small tax (~o.o5%, maybe) on all trades on Wall Street–has been bandied about recently as a means of raising revenues and decreasing volatility in the market.

The idea behind a financial transaction tax, which is a tax on individual market trades, has a smart pedigree. John Maynard Keynes suggested it, and James Tobin, a Nobel laureate in economics, was its most famous modern advocate. Tobin, who died in 2002, wanted to “throw some sand in the wheels” of the markets, and his idea, by Joseph Stiglitz and Lawrence H. Summers among others, is based on an increasingly held belief that markets are far from efficient. Imposing a transaction tax on each individual trade would eliminate wasteful trading and reduce market volatility, ending short-term speculation and mispricing of assets.

This would not be the first time that a financial transaction tax plagued traders on Wall Street; as the author discloses, several instances of such a tax have surfaced before, often to less than satisfactory result.

Let’s start with New York State, which has had such a tax since 1905. Over the next eight decades, the tax was revised up and down nine times, including a large increase in the middle of the Great Depression . In 1966, Mayor John V. Lindsay of New York City ended up raising the tax by 25 percent. It led to an immediate reaction as the New York Stock Exchange threatened to jump across the Hudson River to New Jersey.

In the 1970s, the tax began to be phased out. New York State still collects the tax — some $14.5 billion annually — but since 1981, the state has simply returned it to traders instead of keeping it. In other words, the tax is collected and immediately given back, something that can happen only in the strange world of taxes. (Other financial transaction taxes include a federal version, which was put in effect in 1914 to help pay for World War I and eliminated in 1966, and taxes in Massachusetts and Pennsylvania that were also done away with in the 1950s.)

Unfortunately for advocates of the financial transaction tax, the evidence backs up a piece of theory that most market advocates would cite in the face of such an idea: not only will a financial transaction tax fail to meaningfully reduce volatility in the market, it, like all other government programs, will run the risk of achieving the exact opposite of what it intends to. Volatility will increase due to a smaller number of trades, and investors will increasingly be displaced to regions not collecting such a tax.

A study of New York State’s tax over those eight decades by Anna Pomeranets and Daniel G. Weaver found that it increased the cost of capital for investors and reduced trading volume. Most important, they found the tax actually increased trading volatility by as much as 10 percent.

Increasing volatility is exactly what advocates of the tax don’t want. They want volatility reduced to prevent market disruptions, but the decline in traders in the markets mean fewer buyers and sellers and more price jumps. This finding of increased volatility is in general accord with nine other major papers to study this issue, including studies of the tax in 23 countries, among them Britain, Sweden and Japan. Only one of these papers found that a financial transaction tax reduced volatility.

The New York State tax experience raises a bigger issue — that of traders just going elsewhere. This problem was mirrored in Sweden.

In the eyes of the political class, fluctuations in the market are often seen as a threat and almost never as a positive. This is perhaps because a period of relative inconstancy–I use “inconstancy” because “instability” implies danger–can loom large on the time horizon of a politician up for reelection, and so inconstancies should be avoided whenever the next election approaches (which is, of course, always). But, as Nassim Nicholas Taleb argues, minor shocks are important to keeping markets honest, and help to clear away any fragile components of the market economy without taking down the entire system. As this sort of fluctuation is increasingly eliminated, however, true instabilities become masked, and can become so complexed throughout the financial system or the economy at large that a deviation can have drastic consequences.

So, what can we expect if some sort of financial transaction tax, unlikely though it seems, came to pass here in the U.S.? Well, as it turns out, a natural experiment has just begun in France, so it will be useful to keep an eye on them in the coming year.

Now, we are about to get a real-life case study. France has adopted a 0.2 percent financial transaction tax involving securities of a company with a market capitalization of more than 1 billion euros. The full effects of France’s tax are not yet known, but a preliminary study by Credit Suisse , according to The Economist , found that stocks not subject to a tax rose 19 percent by volume, but those affected by the tax declined 16 percent. And the net effect of the tax appears to have shifted trading to smaller stocks not subject to it, distorting the allocation of capital, which is another problem with the tax . And the European Union has proposed a tax for 11 of its member countries, giving us a possible second test.

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