A U.S. financial transaction tax and the allocation of capital

The U.S. financial services sector has undergone quite a bit of reform since the housing and financial crises of 2007-2009 laid low the global economy. Yet concerns about the scope and role of this industry remain a hot topic of debate. A variety of proposals have been offered that either shrink the financial services industry overall by reducing its profits or use rules and regulations to alter its influence across the economy. But it is the often-discussed financial transaction tax that’s drawing attention anew among policy thinkers. The tax is often seen as a way to reduce the size of financial firms’ profits and perhaps also tweak the relationship between the broader financial system and the decisions of non-financial corporations to create more sustainable long-term economic growth.

A financial transaction tax is quite simple in theory. The government would collect a set percentage of the value of specific transactions, like a sales tax on the sale of stocks, bonds, or other financial instruments. The percentage, however, would be much smaller than the sales tax we’re used to. In an opinion piece for The New York Times, Jared Bernstein looks at analyses of a financial transaction tax of 0.01 percent. While the tax is quite small in percentage terms, Bernstein, a senior fellow at the Center on Budget and Policy Priorities, cites a Tax Policy Center analysis that finds that the tax would raise about $18.5 billion a year over a 10-year period. The authors of that report, which looked at the revenue side of the question, note that while the tax isn’t a huge revenue source overall, it’s certainly not insignificant. For context, the corporate income tax brought in $320 billion in 2014 alone.

But the revenue gained from the tax might serve an ancillary benefit. By increasing the cost of buying and selling different financial instruments, the tax might slow down the rapid-fire movement of capital due to “flash trading” and other high-speed, short-term financial transactions. An article in the Harvard Business Review by Clayton Christensen and Derek van Bever highlighted by Jim Pethokoukis of the American Enterprise Institute argues that a tax on financial transactions is a way to reduce such short-termism.

Often called a Tobin tax after the late economist James Tobin who was an early proponent of taxing short-term financial investments along with John Maynard Keynes, a financial transaction tax also might make investors more cautious about decisions and encourage them to invest over a longer time horizon once they make a choice. Longer-tenured capital would presumably be more interested in seeing companies make long-term investments, which in turn should help boost sustainable economic growth.  One part of the finance sector that’d be especially affected by a Tobin tax would be high-frequency trading firms. These firms make money by very quickly pouncing on small variations in prices. A transactions tax could make this model less viable.

But why should we care about these kinds of firms? Matt Levine at Bloomberg View notes that these high-speed traders profit from identifying gaps between the current prices of financial instruments and future profitability. “Value investors,” who tend to be more long-term focused, would have less incentive to do research if these gaps are closed, knowing that those gaps have already been exploited in the financial markets.

U.S. financial markets haven’t reached a point where high-frequency traders drive out value investors such as Warren Buffet.  A financial transaction tax could be one of several tools to limit the impact of short-term trading on long-term corporate decision-making.

July 28, 2015

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