If you put “FTT” into a search engine, the top results are for “Failure to Thrive.” Proponents of a financial transactions tax should find this disturbing. We find it amusing, but apt.
The idea of taxing the purchase and sale of certain securities has been around for a long time. The British first imposed a stamp duty on secondary market purchases of equity in 1694 – a tax that remains in force today. In 1936, Keynes proposed the imposition of a wider tax with an eye toward reducing volatility. In 1972, following the collapse of the Bretton Woods fixed-exchange-rate system, Nobelist James Tobin famously recommended a tax on currency trading as a kind of capital control that would provide central banks greater discretion in controlling their interest rates and exchange rates. As of 1991, Campbell and Froot list 20 jurisdictions with some form of securities transactions tax. With the move by 11 European Union countries to impose one as of January 1, 2016, the number of countries with an FTT will soon exceed 40.
As it turns out, the United States already has a tiny FTT: to finance the SEC, we impose a tax of 0.184 basis points on stocks and $0.0042 per futures transactions. The resulting revenue leaves the SEC woefully underfunded. (Since 1905, the State of New York also has had an FTT, but the revenues have been instantly rebated since 1981, so the remaining tax is just the cost of filing farcical paperwork and processing round-trip payments.)
More recently, both Hillary Clinton and Bernie Sanders have proposed an FTT. Former Secretary Clinton’s stated rationale is to tax “[high-frequency trading] HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair,” while Senator Sanders’ proposal (see also “Robin Hood Tax”) aims to take from the rich owners of securities and give to college students to pay their tuition.
To be clear, we agree that HFT creates a host of problems; and we believe all qualified students should have access to a college education (see our earlier posts here and here). The question is whether an FTT can accomplish either of these goals. Unless it shifts all trading to an untaxed venue, an FTT will reduce trading in the securities that are taxed, and in that way curtail HFT. But, will it raise substantial revenue? Will it channel resources to more socially productive uses? And, will it (as some advocates claim) reduce market volatility?
The answer to all three of these questions is probably “no.” In the case of an FTT, most of the consequences are likely to be undesirable. The reason is that taxes change behavior. Depending on how an FTT is designed, we can predict with some certainty that it will change where trading occurs, what is traded, or both. So, after people are finished working to avoid the tax, we don’t see how it can meet the goals its proponents have set. Fortunately, wearing our hats as public finance engineers, we can imagine economically efficient ways to achieve these goals, if that is what people really want.
To see what an FTT will do, consider a few examples where they were put in place. First, in the mid-1980s, Sweden imposed a tax on securities trading through brokers within the country. What happened next was predictable: trading moved out of Sweden! The lesson is that if you are going to have a broad FTT, nearly every jurisdiction where transactions can occur had better cooperate. Otherwise, trading will simply re-locate.
Second, the U.K. tax that we just mentioned is imposed on the transfer of the legal ownership of the equity shares for companies registered in the country. What happened? Investor demand increased for equity futures, which were not subject to the tax. The point here is a simple one: when you impose different taxes on different financial instruments that provide the same risk and payoff stream, people will shift their activity to the instrument with the lowest tax rate. So, if you tax equities, but not equity derivatives, activity will shift because the derivatives can replicate the characteristics of the equities. Another example of this is a total return swap, which allows someone to derive the economic benefit of equity ownership without actually owning (or transferring) the security itself.
Some FTT proponents call for taxing derivatives as well (see, for example, the “Robin Hood tax”). However, that would be enormously complex and – in many cases – easy to avoid. For example, the European Union’s proposal to tax notional amounts is destined to fail because the derivatives contracts can be re-designed to achieve the same risk transfer with a smaller notional amount. And, again, taxing derivatives in one jurisdiction will almost surely shift trading elsewhere.
So, while an FTT will reduce the trading of a legal instrument in a jurisdiction where it is taxed, it probably will not materially decrease trading in the risk and payout characteristics that are embodied in that instrument. In addition, simple tax schemes that end up imposing differential taxes across instruments run the risk of distorting not only capital markets but also the way in which firms finance themselves. Taxing equities favors issuance of debt; taxing long-term bonds but not short-term liabilities will lead to a reliance on short-term obligations; and even a well-designed tax that taxes equity and bonds with equal impact will encourage an increased on reliance on bank loans. That is, an FTT could easily leave us with more illiquid securities, more short-term debt, and a more bank-centric financial system. (For a detailed discussion of these complex design issues, and proposed solutions, see here.)
We can now answer the first two questions posed earlier: tax arbitrage will render an FTT ineffective. First, while a well-designed tax will raise some revenue in the short run, shifts in the location and composition of trading are likely to erode the tax base quickly. Second, talented corporate lawyers and financial engineers will find ways to replace high-tax instruments with low-tax equivalents. Put differently, while an FTT might reduce the very costly and unproductive location of traders’ computers physically close to matching platforms, it will spur the creation of new products with little social value.
The final issue is volatility. Here, things are unclear. Since an FTT will reduce trading volume, drive down market liquidity and widen bid-ask spreads, it seems more likely to drive price volatility up, not down. But the empirical evidence (summarized here) is inconclusive. In practice, whether an FTT raises or lowers volatility depends on the structure of the market and the composition of its participants. For example, the more mature the market, the more sophisticated the participants, and the faster that available information is reflected in asset prices, the more likely volatility will rise. The reason is that – in the presence of an FTT – a security’s price will need to be further displaced from its fundamentally warranted level to make stabilizing trades profitable.
Fortunately, there are ways to meet the objectives of FTT proponents. Good tax policy raises revenues in the least distortionary fashion. An FTT fails this test. Instead, applying the most basic lesson from public finance, we should tax something for which the supply or demand is inelastic. And, since FTT proponents wish to take from the rich and give to the poor, we should tax that subset of inelastically demanded things that rich people cherish and poor people do not own. Following Henry George’s advice from 1871, one solution is to tax land, which also has the virtue of encouraging more efficient land use. To this, one might add a shelter-free tax on large-scale inheritance, provided that the expected benefits are not offset by the impact on entrepreneurship, labor supply and savings.
Second, if the goal is to improve market function by reducing high-frequency trading, an FTT is ill suited to the task. Instead, as we wrote in our earlier post, policymakers could either impose a fee on orders that are cancelled within a few seconds, or introduce frequent batch auctions (say, at one millisecond intervals) to “transform competition on speed into competition on price.” Neither approach would be likely to reduce market liquidity as much as an FTT.
All in all, an FTT will almost surely fail to thrive. It will fail to collect much revenue; it will fail to curtail unproductive activity; and it will likely to fail to reduce market volatility. Its unintended consequences – such as a loss of market liquidity – could be very costly. Fortunately, if we wish to achieve those goals, there are effective ways to do so.