The Perils Of A Financial Transaction Tax

Introduction

Following the GameStop saga, D.C. lawmakers have renewed calls for the imposition of a financial transaction tax (FTT). FTTs—essentially a tax on every stock market trade—are often cited as an easy way to collect tax revenue and reduce volatility in equity markets. However, the data is pretty clear that these cited benefits are significantly overblown.

First, let’s dig a little deeper into what an FTT is. At its most basic level, an FTT is a tax applied on either the buyer or seller of a security at the time of a financial transaction. These taxes can be implemented to involve specific types of securities, or be applied selectively to certain types of investors. There have been numerous different legislative proposals in recent years, but the latest one was introduced by Sen. Brian Schatz (D-HI) and would impose a tax on the sale of stocks, bonds, and derivatives at 0.1%.

Sen. Schatz and others have indicated an FTT would reduce financial market volatility and market speculation. In fact, an FTT may actually deteriorate market quality, reduce liquidity through increased bid-ask spreads, and increase market volatility. Let’s explore why.

An FTT Will Make Markets Less Efficient

A large pillar of support for an FTT stems from the belief that high frequency trading (HFT)—the use of powerful computers to conduct a high number of trades in fractions of a second—and electronic trading cause volatility due to speculative trading. These attacks have been proven time and again to be false, and research has confirmed that these innovative trading practices have increased market efficiency, liquidity, and stability, creating a more reliable equity market structure that better serves investors during times of stress and calm alike.

Further, evidence from other countries which have implemented FTTs show they do not improve markets. Stocks subject to an FTT in France were traded less frequently, increasing spreads relative to their peers, hurting investors, and decreasing market efficiency. (A bid-ask spread refers to the gap between the ask price and the bid price for an asset in the market; a narrower spread signals high liquidity and efficiency and low transaction costs.) Research on France’s FTT published in January 2021 in the International Review of Finance concluded, “FTTs deter informed trades and reduce market quality.” A similar study published in the Journal of Financial Services Research in 2014 found that the French FTT had a significant impact on market quality, dropping trading volume by one fifth and resulting in a reduction in volume posted at best prices. Similarly, the European Central Bank found evidence that an Italian FTT, “widened the bid-ask spread and increased volatility” in a 2016 research report on the effects of the FTT.

In short, the observed impact of FTTs is that they discourage short term trading, disincentivizing transactions that help stabilize markets and generate price efficiency.

An FTT Isn’t The Revenue Machine Proponents Promise

FTT proponents may acknowledge that the tax might make markets less efficient but that it is worthwhile because it will bring in new tax revenue. That assertion requires a lot of caveats; perhaps most important among them is that the revenue will be raised on the backs of Americans saving for retirement.

Any American with a 401(k), for example, would be subject to the tax every time their fund buys or sells a stock or bond. More than 54% of Americans are invested in the stock market, either directly or through a retirement fund such as 401(k) or IRA, and over 40% of Americans are invested in college education savings plans such as 529.

The impact on retirees would be particularly severe. Consider that 401(k) savings plans primarily benefit middle class families, with 80% of participants in 401(k) plans making less than $100,000 per year, and 43% of participants making less than $50,000 per year. For this group, a 10-basis point (0.1%) FTT would force an average investor to work nearly 2½ years longer than what they would have to work in order to reach the same savings goal without an FTT, according to the investment firm Vanguard.

Further, at a time when we need to spur as much investment into the American economy as possible, an FTT would be an inefficient investment mechanism as it will hinder private sector investment and may fail to materialize the revenue it promises. 

According to a 2011 letter from the nonpartisan Congressional Budget Office, an FTT  “would raise the costs of financing investments to the extent that it made transactions more expensive, financial markets less liquid, and management of financial risks more costly.” As a result, many businesses, as well as state and local governments, looking to finance their activities would face higher costs of borrowing. For example, although municipalities wouldn’t have to directly pay the tax when they issue securities on the market, investors may likely seek higher interest rates on them as they would have to factor the tax into the purchase or sale of these securities on the secondary market. These higher interest rates could in turn hinder government investment for a range of crucial services.

Furthermore, researchers at the CBO also found that a financial transaction tax would affect the funding of state and local pension plans. “Besides initially reducing the value of their existing assets slightly, the tax would raise transaction costs for pension plans. Both of those effects would increase required contributions to the plans,” the letter states.

Critically, the revenue-generating potential of an FTT remains uncertain. A tax that is too high or too narrow could create distortions by encouraging investors to either leave the market or create “synthetic” securities to yield the same economic return without being subject to the tax. According to the Congressional Research Service, “at this point, it is difficult to predict exactly how traders’ behavior will change in response to a tax.”

The Final Word

An FTT is not a new silver-bullet tax policy. Based on results and analysis conducted on the FTTs in France, Italy, and Sweden, it’s clear the policy too frequently over-promises in rhetoric and under-delivers in practice. There are plenty of substantive enhancements that could help strengthen current market dynamics, but an FTT is not one of them. Federal policy should be designed to foster innovation, expand access, and enhance market quality for a U.S. financial system that remains the premier global market. Policymakers should turn their attention to better developed policies that ensure U.S. capital markets remain deep and liquid while delivering positive returns for retirees, pensioners, and investors.