On Friday, Feb. 28, the S&P 500 ETF SPY traded over $100 billion in volume in a single day. With a .1% financial transactions tax, something that a few U.S. presidential hopefuls had proposed, that volume would have generated $100 million in government revenue.
Those types of numbers have lawmakers salivating over the potential to raise untold amounts of money from applying very small fees to stock, bond and derivatives trades — so small that people wouldn’t even notice.
But financial transactions taxes have also become a rallying cry among U.S. Democrats, like Senator Bernie Sanders, seeking to rein in Wall Street. The idea is that those taxes would discourage pointless speculation and high-frequency trading, returning our markets to the halcyon days when transaction costs were high and people traded less.
Lots of people dislike fees of all kinds — brokerage commissions, mutual fund loads and so forth — and many are also ambivalent about the potential for significant taxes on trades, which eat into investors’ returns over time. In fact, this has been the argument against financial transactions taxes for decades: It’s not “Wall Street” that pays, but individual investors.
Vanguard, the low-cost mutual-fund company, has come out hard against financial transaction taxes, saying that they would make the average investor work two and a half years longer before retiring. Vanguard also found that the negative impact of a tax on a theoretical actively managed small-cap equity fund would be approximately -19% over a 20-year period. Before you say that passively managed funds would be mostly exempt from these taxes, know that they, too, would be subject to the tax when funds are deployed and when stocks are added and deleted from the index.
Really, the argument against financial transaction taxes comes down to the negative impact they would have on liquidity — the ability to easily convert assets into cash. The U.S. has the deepest, most liquid capital markets in the world, which might be somewhat correlated to economic growth and financial assets’ performance. If a financial transactions tax had been in effect on Feb. 28, for example, there probably wouldn’t have been $100 billion of volume in SPY that day. Some people estimate that financial transactions taxes would cause volumes to drop in half; I estimate that they would drop 70% to 90% or more.
Liquidity is the lifeblood of financial markets. And as fragmented as today’s markets are, and as different as they are from the old days of the specialist on the floor of the NYSE, they still do a terrific job of providing liquidity. In equities, there are far fewer block trades, and most trades are done algorithmically, but I don’t hear people complaining that they don’t have the ability to execute trades at reasonable prices. The corporate bond market has had some well-publicized liquidity issues (which have abated somewhat), but this crisis was mostly man-made, owing to regulation and capital requirements. If you followed the story, you know that for a while, money managers had a very difficult time transferring risk in the bond market, which was not good. Liquidity problems also tend to trickle down from the markets to the real economy, and even routine functions of the banking system such as issuing mortgages may become impaired. A financial transactions tax would exacerbate these issues, by providing a powerful disincentive for market-makers to provide liquidity.
What it comes down to is the ability to transfer risk. America’s financial markets are better than all others at doing that, in large part because transaction costs are basically nonexistent, aside from a tiny SEC fee. If you can’t transfer risk when times are bad (or good), then the coronavirus crisis that we are experiencing becomes much worse, as people’s ability to trade is weakened and positions get marked relentlessly lower.
Now let’s go back to the idea of revenue collection. Bernie Sanders claimed to be able to make college free on the basis of a financial transactions tax. This simply is not possible. Volumes would essentially disappear, and based on my years of trading experience, I’d say the revenue collected might be as low as 10% or 20% of what is advertised. It would nuke liquidity in the financial markets with very little benefit to show for it. I’d go as far as to say it could be the most destructive tax ever imposed.
As for the all the fuss over speculation, I don’t believe that speculation should necessarily be reduced. In fact, it should be encouraged. Healthy speculation ensures that assets like stocks and bonds, commodities and real estate are fairly priced. Occasionally, people find it distasteful when asset prices are driven to extreme levels. But the best cure for speculation is more speculation, and when the authorities try to tamp down on it (such as periodic attempts to ban short-selling, like during the financial crisis), it usually has unintended consequences.
It’s discouraging that financial transactions taxes have more or less become a plank of the Democratic Party platform. Perhaps it’s inevitable, as people are going to be angry about the financial crisis for generations. But for those who want to take it out on Wall Street, there are better ways that don’t leave retail investors as collateral damage.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of 'Street Freak' and 'All the Evil of This World.' He may have a stake in the areas he writes about.
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