Taxing financial transactions?

With federal budget deficits soaring all over the world, policy makers are looking at every opportunity to find new sources of revenue. After the bailouts of the financial sector and public backlash against announcements of large profits and bonuses by banks, a financial transactions tax appears to be a popular proposal both in the U.S. and abroad to "recoup" costs from the financial services industry. But is it really a good idea?

Following James Tobin’s original proposal, governments would place a small tax on financial transactions to discourage speculators (who trade frequently) without putting an undue burden on investors who buy for the long haul. Such a national transaction tax, at a rate of 0.1% to 0.25% of the value of the trade, would be levied on all financial transactions such as stock trades, but not on consumer transactions like credit cards. Advocates in the U.S. argue that it would raise $100 billion to $150 billion a year. Many economists – including prominent figures like Paul Krugman, Joseph Stiglitz, and Jeffrey Sachs – have backed the tax.

There's little disagreement that by picking up the bill of the bailout, taxpayers got a lousy deal in the financial meltdown. But is a levy on financial transactions likely to help pay for the cost and ensure that taxpayers are less likely to pay in the future? Unfortunately, in both cases the answer is likely 'no'.

One difficulty of taxing financial transactions is that funds can easily flow across borders and start trading elsewhere. For example Sweden tried a tax on stock and bond trades in 1980s, but abandoned it after Swedish investors circumvented the tax by trading abroad, resulting in a decline in domestic trading volumes. Implementing such a tax would require significant international coordination since all those who are taxed would seek to escape the tax by moving activity to another country. Despite the difficulties involved, coordinating such a tax might be feasible given recent worldwide action to restrict the movement of financial flows to tax havens and technological advances now available to tax authorities.

But even if the coordination problem could be overcome, another problem remains: the base of such a financial transaction tax is likely to be very elastic in response to the tax. In other words, even a very small tax may dramatically alter the way in which wholesale participants in financial markets behave. So even if it were possible to prevent flight to tax havens with the introduction of a transactions tax, the volume of transactions is likely to collapse, disappointing those who hoped to raise significant revenue through the tax. And since speculation is not easy to identify, such a tax will end up making it more costly to hedge risks as well.

Those advocating the tax as protection against future crises are not likely to find what they are looking for either. A transactions tax would have little effect in discouraging the activities of the credit default swap market or the market in securitized sub-prime mortgages, which have both been blamed for contributing to the recent crisis. It is also not obvious such a tax would reduce the volatility of asset prices; for example buyers in Britain's housing market have been required to pay a transaction tax on their purchases for years. We still need effective regulation and supervision to curb crises, taxes just can’t do that job.

Further Reading:

Patrick Honohan and Sean Yoder. 2011. "Financial Transactions Tax: Panacea, Threat, or Damp Squib?" World Bank Research Observer 26 (1): 138-161.