Noll: The Perils of a Financial Services Transaction Tax
The financial crisis and economic recession have brought about pain and suffering for millions of Americans. The debate about what went wrong, who is to blame, and most importantly, how to fix our system so a similar crisis doesn’t happen again, has only just begun. The public is angry, and Congress is under pressure to take action to make Wall Street pay back Main Street. And while the sentiment is warranted — and certainly action is needed — there is one proposal that has been floated by some lawmakers that will miss the intended target and hit American investors.[IMGCAP(1)]That proposal is to impose a securities transaction tax of 0.25 percent on stock transactions, 0.02 percent tax on futures contracts, swaps and credit default swaps, and an unspecified tax on options. The tax would be refunded for retirement and pension accounts, mutual funds, education savings accounts, charities, colleges and universities, health savings accounts, and the first $100,000 of transactions annually that are not already exempted. It is estimated that $150 billion would be generated by the tax. These funds would be used to support the Job Creation Reserve fund and the Surface Transportation Authorization Act of 2009, and reduce the deficit. As a rule of thumb, taxes are used to encourage or discourage certain behaviors by altering the balance of supply and demand. In this particular case, it is believed that the transaction tax will curb speculation in the financial markets by making securities less attractive to professional traders.While the supporters of the transaction tax argue that it could penalize speculators, it will also hurt retail investors and cycle through to the U.S. economy as a whole. It is a tax on market liquidity. It will lead to a self-perpetuating cycle of lower volumes, higher transactions costs, lower share prices and diminished returns. Lower volumes and less liquidity make it more difficult to raise capital — and a diminished ability to raise capital hurts the ability of companies to invest, grow and create jobs. In speaking about the transaction tax, lawmakers are wielding a policy tool that will slow economic growth. In some cases, such as when the Federal Reserve raises interest rates to cool growth and tamp asset bubbles, government is purposefully looking to cool economic growth. I don’t think anyone in Washington, D.C., is seeking to slow down economic growth. A transaction tax would be a disincentive for self-directed investors. While the proposed tax may seem trivial, it actually creates a significant increase of the overall transaction costs. Investors will find it harder to cover their costs, so they will trade less. As volumes decline, economies of scale will be eroded, and transaction costs will increase. Weaker demand as well as the tax itself will reduce liquidity. The inability to buy and sell securities will drive bid/offer spreads wider, thus making it more difficult for individual investors to break even and turn a profit on their trades. These wider spreads are a real cost to all investors — including retail investors.Securities’ trading is a scale business: The higher the volumes, the more competition; the tighter the spreads, the cheaper it is to trade. Advancements in technology over the past couple of decades have driven economies of scale resulting in lower transaction costs that have been passed through to investors. Today, retail investors pay extremely low commissions through online brokers. In addition, the structure of the U.S. equity and options encourages competition driving a tighter bid/offer spread, reducing costs for all market users. The proposed tax directly moves this process in the opposite direction. Finally, millions of people save for their retirement by investing in mutual funds, which enjoy a low-cost base thanks to scale economies.Under the proposal, retail investors will not be taxed directly for mutual fund purchases, but the mutual funds themselves will be taxed. On average, a portfolio manager turns over his fund’s holdings every one to two years; some do it more frequently. A mutual fund’s cost basis could potentially double, and that overhead will be passed through to fund holders. While a tax of 0.25 percent may seem small, keep in mind that if mutual funds only return 3 percent over inflation, 0.25 percent equals 8 percent of that return, which is a significant difference.When compared to the capital gains tax, the transaction tax is far more punitive and all-encompassing. Investors only pay capital gains if their trade results in a profit. In contrast, investors will pay the transaction tax even when their trade results in a loss.The transaction tax will encourage investors to change their behavior in other ways. Instead of putting their money into securities, they will buy asset classes that are transaction tax-exempt. As a result, the government will fail to reach its target of $150 billion raised through the tax, but will damage our capital market’s abilities to raise capital to grow the U.S. economy.Past experience has demonstrated how other markets have tried and failed to implement transaction taxes. For instance, in the mid-1980s in Sweden, a 1 percent transaction tax was introduced and then doubled. By 1990, more than 50 percent of the volume in Swedish shares traded in London. Fortunately, the taxes were abolished in 1991, and today the Swedish markets are again dynamic and growing. This is a lesson that does not need repeating.It is important to hold accountable those who were responsible for leading our nation into economic meltdown. Congress is acting with the best of intentions. However, we must take care not to implement policies that will have negative consequences for private individuals who have worked so hard to save for their future, and for the companies that underpin the U.S. economy.Eric Noll is executive vice president of NASDAQ OMX Transaction Services.