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Financial transaction taxes in theory and practice

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In response to the financial market crisis and Great Recession, there has been a resurgence of interest in financial transaction taxes (FTTs) around the world. We estimate that a well-designed FTT could raise about $50 billion per year in the United States and would be quite progressive. We discuss the effects of an FTT on various dimensions of financial sector behavior and its ambiguous effects on economic efficiency.

The Great Recession, which is largely thought to be due to financial market failures, has prompted renewed calls for a financial transactions tax (FTT) to discourage excessive risk taking and recoup the costs of the crisis. The chorus of FTT advocates includes Bill Gates, Jr., George Soros, and Pope Benedict XVI. The idea is not new, however. Keynes proposed an FTT in 1936 as a way to discourage the kind of speculation that fueled the stock market bubble that led to the Great Depression. More recently, leading economists Tobin (1978), Stiglitz (1989), and Summers and Summers (1989) have advocated similar taxes.

Taxes on financial transactions have a long history. The British stamp duty was enacted in 1694 and remains in effect today. The United States imposed a nontrivial stock transactions tax from 1914 to 1965, as did New York State from 1905 to 1981. An extremely small securities transfer tax currently funds the Securities and Exchange Commission (SEC). FTTs have long been popular in less developed countries as a way to raise significant revenue from a small number of relatively sophisticated financial entities.

The FTT is experiencing a resurgence in the developed world. Eleven European Union (EU) countries have agreed to enact a coordinated FTT that is scheduled to go into effect in January 2016 (assuming participant countries can work out some significant differences). France adopted an FTT in 2012 that will be integrated with the EU tax if and when it takes effect. In the United States, several recent Congressional proposals for FTTs have been introduced by Representative Peter DeFazio (D-OR) and Senator Tom Harkin (D-IA), by Representative Keith Ellison (D-MN), and by Democratic presidential primary candidate Bernie Sanders (I-VT).

Proponents advocate the FTT on several grounds. The tax could raise substantial revenue at low rates because the base—the value of financial transactions—is enormous. An FTT would curb speculative short-term and high-frequency trading, which in turn would reduce the diversion of valuable human capital into pure rent-seeking activities of little or no social value. They argue that an FTT would reduce asset price volatility and bubbles, which hurt the economy by creating unnecessary risk and distorting investment decisions. It would encourage patient capital and longer-term investment. The tax could help recoup the costs of the financial-sector bailout as well as the costs the financial crisis imposed on the rest of the country. The FTT—called the “Robin Hood Tax” by some advocates—would primarily fall on the rich, and the revenues could be used to benefit the poor, finance future financial bailouts, cut other taxes, or reduce public debt.

Opponents counter that an FTT is an “answer in search of a question”. They claim it would be inefficient and poorly targeted. An FTT would boost revenue, but it would also spur tax avoidance. As a tax on inputs, it would cascade, resulting in unequal impacts across assets and sectors, which would distort economic activity. Although an FTT would curb uniformed speculative trading, it would also curb productive trading, which would reduce market liquidity, raise the cost of capital, and discourage investment. It could also cause prices to adjust less rapidly to new information. Under plausible circumstances, an FTT could actually increase asset price volatility. An FTT does not directly address the factors that cause the excess leverage that leads to systemic risk, so it is poorly targeted as a corrective to financial market failures of the type that precipitated the Great Recession. Opponents claim that even the progressivity of an FTT is overstated, as much of the tax could fall on the retirement savings of middle-class workers and retirees.

This paper addresses these issues, with particular attention to the question of the potential applications of such a tax in the United States. Our review and analysis of previous work suggests several conclusions. First, the extreme arguments on both sides are overstated. At the very least, the notion that an FTT is unworkable should be rejected. Most EU countries have or are planning to adopt FTTs, and many world financial centers, including Hong Kong, Switzerland, Singapore, South Africa, and the United Kingdom, thrive despite the presence of FTTs. Similarly, the idea that an FTT can raise vast amounts of revenue—1 percent of gross domestic product (GDP) or more—has proved inconsistent with actual experience with such taxes.

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