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January 18, 2009

Will a Tobin tax help prevent financial crises?

In Where the Money Is, New York Times Op-Ed writer Bob Herbert advocates a tax on every financial transaction.

The economist Dean Baker is a strong advocate of a financial transactions tax. This would impose a small fee -- ranging up to, say, 0.25 percent -- on the sale or transfer of stocks, bonds and other financial assets, including the seemingly endless variety of exotic financial instruments that have been in the news so much lately.

According to Mr. Baker, the co-director of the Center for Economic and Policy Research in Washington, the fees would raise a ton of money, perhaps $100 billion or more annually -- money that the government sorely needs.

But there’s another intriguing element to the proposal. While the fees would be a trivial expense for what the general public tends to think of as ordinary traders -- people investing in stocks, bonds or other assets for some reasonable period of time -- they would amount to a much heavier lift for speculators, the folks who bring a manic quality to the markets, who treat it like a casino.

In general, this kind of tax is called a Tobin tax. Originally coined for a transaction tax in currency markets, this tax is an attempt to raise money and throw sand in the smooth operations of financial markets.

It is possible that this sort of tax could raise a lot of money. It is also possible that it could throw a lot of sand into capital market operations. But not both. Like cigarette taxes that can raise a lot of money or discourage a lot of smoking, it can only raise a lot of money by existing in an environment where a lot of people trade, and create a frictions by discouraging people from trading and therefore not paying the tax.

If this law comes about, I'd expect to see a massive effort to avoid this tax by holding and trading assets outside of the United States. I would expect that effort to succeed on many products, especially ones that do not trade on exchanges. The ones that do trade on exchanges in the USA would probably continue to do so, and therefore pay the tax. How much would their trading volumes decline? Many products trade with a bid-offer spread of more than .25% already. To people are already willing to pay a large tax on the value of their assets in order to trade. Would they be willing to pay one .25% more? In the 80's when computer technology was more primitive, trading volumes were lower and spreads larger on most products. But for stock spreads to be on average .25% higher, you don't have to go back that far. Early to mid 90's would be enough (depending on which study you believe and how you calculate it). Going back to the mid-90's volume would make NYSE volume fall by about 75%. I don't know what the elasticity of demand for trade is with respect to the price of trading, but if this method is indicative it suggests that most of the effect will be on volume. Seeing a quartering of trading volumes would do massive damage to the US as a financial center, and that's an expensive way to raise $100 billion a year. In contrast, we could raise that much money by increasing the national income tax by about .7%.

When designing taxes, you should care about their excess burden. That is, how much economic distortion do they encourage compared with the revenue they generate? Tobin taxes have massive excess burden. Don't have them.

I think what this policy confuses is a flurry of activity with a flurry of speculation. High trading volumes are good. Having a diverse group of market participants with different savings horizons, goals, and risk appetites is good. Even the knowledgeable people who think that speculation is bad think that. So why punish those activities we know to be good to discourage a policy (speculation) which is at best of unknown value. If we want to target speculation, we should do that directly. We currently do that by having a different capital gains rate for short term and long term holding. We can also do that by regulating or taxing leverage.

Posted by OneEyedMan at January 18, 2009 8:34 AM

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