With billions of dollars in year-end bonuses being paid out by banks that only survive thanks to government help, Congress is eyeing the financial sector's coffers as it grapples with a record deficit. And though the government remedies that eased the recession aren't the largest cause of our budget shortfall, having banks chip in to make up the cost makes sense. That's why Sen. Tom Harkin and Rep. Pete Defazio proposed a financial-transactions tax (FTT) in early December.
The modern FTT has its roots in the work of famed economist James Tobin, who originally proposed a small tax on foreign-currency trading to throw "sand in the gears" of speculation that makes money without social benefit. The byproduct, of course, would have been increased government revenue. The current proposals, which place a similarly small tax on the exchange of stocks, bonds, and derivatives, promise a similar twofer: limiting unhelpful speculation while raising much-needed public funds.
The move is supported by prominent liberal economists like Paul Krugman and Dean Baker as well as by the AFL-CIO. It is opposed by the financial industry, congressional leaders, and the Obama administration. Given this opposition, and because the policy will do little to limit speculation, it would be smarter to find a different way to tap the banks' largesse for the public good, perhaps through a tax on bankers' bonuses like that under consideration in the United Kingdom, and instead advocate for a global (rather than a U.S.-level) agreement on a financial-transactions tax as part of the broader financial regulatory reform effort.
Taxes on financial-asset exchanges already exist in many major international markets. The Securities and Exchange Commission, for instance, funds itself through a small tax on securities traded in the U.S., while in the U.K., a stamp tax on domestic securities raises several billion pounds a year. Proponents of the FTT argue that if these leading markets can bear such taxes, U.S. markets should be able to handle similarly small taxes -- a few hundredths of a percent across different types of assets.
The first question is whether raising the transaction costs via an FTT can actually limit economically inefficient speculation by arbitrageurs and noise traders who make money playing market trends, or lessen the use of risky short-term financing. Jan Kregel, director of the Levy Economics Institute of Bard College, doesn't think that such a tax would have much effect on preventing highly leveraged speculation, simply because the amounts of money in play are so large compared to the miniscule tax.
"The size of the tax you were looking at would not be a deterrent. The argument then shifted, and people said it was a good way of raising revenue," Kregel says.
The tax could be effective, Kregel admits, in limiting smaller-scale speculators who use high-speed computerized trading to play the markets, relying on many small trades a day to earn massive profits. While some of these techniques are pernicious and should be banned, as the SEC is doing with "flash" trading, high-frequency trading provides much of the liquidity -- the ability of traders to sell assets quickly -- in markets that used to come from specialists at exchanges. High-frequency trading makes up around 70 percent of trading volume, and industry representatives argue that this is beneficial to all investors.
Academics are split on how much liquidity is actually provided by high-frequency traders and how much is actually needed. The extinction of high-frequency trading due to an FTT could have unintended consequences -- while losses in liquidity could be easily borne by the industry, it's also possible that such a move could cause real problems among still-weak banks.
What the tax could do, if broadly leveled across markets, is drive traders toward the so-called dark pools, loosely regulated proprietary exchanges within major banks. While the tax's authors believe that the tax would still be collected there, it doesn't strike me as wise to give bankers more business, although the SEC is also proposing stricter regulations on these practices as well. Given large investors' ability to avoid regulation, this could leave retail investors holding the bag; in the U.K., for instance, the tax has been narrowed in scope over the years so that it brings in lower revenue and falls on smaller investors.
What worries U.S. officials most is that the tax could send traders to markets outside of the United States. Many experts consider the prospects poor for Harkin and Defazio's legislation because of the amount of international coordination required to keep regulations consistent across borders and prevent regulatory arbitrage as traders seek the loosest markets, even though most agree that Wall Street is overstating its ability to pick up its toys and leave.
"If you're going to do something that is moving the needle on revenue, it has to be relatively sizable," says Obama economic adviser Austan Goolsbee, a student and friend of Tobin's. "It is very difficult for one country alone to do that when transactions are so mobile, so that's got to be done in some international context."
Proponents of the FTT suggest that the tax could bring in as much as $100 billion a year, which would not be an unwelcome addition. (Though, for perspective, budget officials recently announced that the TARP program will cost $200 billion less than anticipated.) Some of that revenue could be found through more-direct measures: One is a bonus windfall tax, which could be levied on discretionary bonuses that are more than $50,000. Another is raising the capital-gains tax and altering it to place greater emphasis on holding assets in the long term.
The real problem with the FTT is that, as long as it cannot limit major speculation, it treats the financial sector as a cow to be milked, not a problem to be shrunk. Legislators need to focus on ways to make the banks carry less risk -- and hence be less profitable -- not on how to tax those profits more effectively. Let's limit leverage and raise capital requirements, create rules like the Miller-Moore Amendment that would limit risky overnight financing, narrow the scope of commercial bank activities, and bring derivatives and other unregulated markets into clearer view.
As a part of that effort, the U.S. should introduce a framework for a global financial-transactions tax to be part of the G-20's international agenda -- Secretary of the Treasury Tim Geithner was wrong to rule such discussion out of bounds during the organization's last meeting. But first, he should work to strengthen the regulatory reforms passed in the House and push them through the Senate intact and with fewer loopholes.
