Q. Have financial transaction taxes been tried before?
Yes, financial transaction taxes were widely imposed around the world until the financial deregulation of the 1990s. The United Kingdom continues to impose a 0.5 percent stamp tax on stock trades; this tax raises tens of billions of dollars a year.
Q. How will the tax be collected? Will there be added paperwork faced by investors or money managers?
A. The financial transactions tax would be collected by the broker executing the transaction in the same manner that the small transaction tax presently imposed to fund the U.S. Securities and Exchange Commission is today. A tax credit of up to $250 per individual ($500 per couple) would be claimed on annual tax forms, that would return the tax paid on the first $100,000 of taxes paid each year.
Q. Some option trading and derivative trading provides a useful function, such as correcting excessive valuations of stocks, or hedging legitimate business risks (such as airlines purchasing futures contracts to protect themselves against rising oil prices). Won’t this tax discourage these activities?
A. It is true that some trading of options, futures and derivatives provide a useful economic function, however, up to 70 percent of the trading activity in some markets is short-term and speculative and looking to generate pennies of profit from small changes in the price of securities. For speculators the cost of the tax is prohibitive, but for those using hedges for legitimate business reasons, the cost of the tax is affordable. For instance, it would cost an airline $80 to hedge $400,000 of jet fuel purchases. If a small tax on futures contracts rids the markets of those whose only interest is making money from short-term speculation, it would be a small price to pay for legitimate businesses to enjoy more stable financial markets and commodity prices.
Q. Doesn’t placing a tax on securities trades raise the cost to responsible investors and undo the good done by increasing competition among brokers?
A. Placing a small tax on securities trades does increase the cost of trading for all investors – responsible ones and speculators alike. But the amounts we are talking about are quite small – a penny on every four dollars of assets traded. The tax would cost someone buying $10,000 worth of stock just $25. If the average investor typically holds a stock for five years, then the transaction cost associated with the investment would reduce annual performance of their portfolio by 0.1 percent per year, a fraction of what is paid in management fees in mutual funds or individually managed accounts. For this small fee, they would get markets that are more stable.
Q. If the US imposes this tax, won’t the speculators just take their trading elsewhere in the world, where such taxes are not imposed?
A. There are already differences in trading costs in markets of the world. Established markets in the United States and Europe are preferred trading venues because of the security they afford to investors. European Union member states, which would be the most likely alternative trading venue, have also called for various financial transactions taxes. Finally, the current proposed legislation in the Senate would impose the financial transactions tax on U.S. citizens and U.S. corporations regardless where in the world the transaction occurs.
Q. If the tax, as expected, reduces trading volumes, won’t this reduce market liquidity?
Imposing the tax would reduce trading volumes and return liquidity levels to those seen 25 or 30 years ago, when transaction costs were similar to those that would be in place if the proposed tax was implemented. We would also expect to see returns to the much lower levels of volatility experienced a generation ago.
Q. Would the tax be collected on mutual fund investments?
A. Purchases and sales of mutual funds would be exempt from the financial transaction tax. However, mutual fund portfolios would pay the tax on purchases and sales within the fund. The Investment Company Institute, the trade association of the mutual fund industry, estimates that the proposed tax would cost the average actively managed mutual fund owner 0.14 percent in return each year (index funds would pay on average 0.05 percent). In contrast mutual fund research leader Morningstar estimates that 12b-1 fees used by many mutual funds to pay their marketing expenses reduce returns by 0.36 percent annually. For the much smaller fee imposed by the financial transaction tax, mutual fund investors would receive more stable markets, protecting their assets from financial speculators.