Taxing the Reckless


In the 1960s, the financial sector made up 3.5% of the economy. Today, it's about 8.5%. In 1960, the average stock was held for 100 months. By 2009, it was flipped every eight months. Before Goldman Sachs (NYS: GS) went public in 1999, trading made up 28% of revenue. By 2009, it was 81% of revenue.

It's numbers like these that cause some to suggest a way to clamp down on, or at least discourage, speculation in financial markets.

The most popular way is a transaction tax, which essentially acts as a sales tax on trading securities. Even a tiny tax would discourage speculators from creating havoc by jumping in and out of the market, the thought goes. To boot, hundreds of billions of dollars on tax revenue can be raised with a tax so small that most individual investors would hardly notice it. It seems like a win-win.

One such idea is making its way through Congress. Rep. Peter DeFazio (D-Ore.) and Sen. Tom Harkin (D-Iowa) have introduced a bill called the Wall Street Trading and Speculators Tax Act. The bill proposes a 0.03% tax on all financial transactions, or 3 cents for every $100. People's interest in the bill perked up last week after the nonpartisan Joint Tax Committee said it would raise $350 billion in new tax revenue over the next nine years. That's more than three times the budget of the Department of Education.

Will it work?

I love the idea in theory, but there are good reasons to be skeptical.

As Jason Zweig of TheWall Street Journal recently pointed out, New York implemented a transaction tax in 1905. Far from curbing speculation, the tax may have helped push it through the roof:

The first day the law was in effect, a broker named Albert Hatch flouted it, eventually taking his defiance all the way to the U.S. Supreme Court -- which ruled the law constitutional.

Instead of discouraging traders, however, the new tax seems to have lit a fire under them.

With their dollar gains per trade reduced by roughly one-fourth, speculators had to sprint faster just to stay in place.

The first month under the new law, trading ran 2.5 times higher than the same month the year before, reported the Quarterly Journal of Economics late in 1905. Annual trading volume for the full year exceeded 210 million shares, up by one-third from 1904. Annual turnover hit 244% -- meaning the typical share changed hands every five months, a pace that would never again be equaled in the 20th century, according to data from the New York Stock Exchange.

The unintended consequences of a transaction tax would be very different today, but potentially as chaotic, as Zweig notes:

As markets became more competitive, the New York tax became less practical and was finally phased out in 1981.

Today, the unintended consequences could be at least as severe, in the opposite direction.

The typical high-frequency firm earns a profit of well under one-hundredth of 1% per transaction, say traders and analysts.

A tax rate of just 0.01% "would instantly wipe out [high-frequency trading]," says Manoj Narang, chief executive of Tradeworx, a high-frequency firm in Red Bank, N.J.

With high-speed traders accounting for roughly two-thirds of all volume, such a result would likely be highly disruptive to the market.

Why is a little technical. Think about the May, 6, 2010, "flash crash." Most people finger high-frequency traders for the crash. Interestingly, it wasn't because of what they did, but what they didn't do that caused chaos. As high-frequency traders stopped trading and exited the market, their role in providing market making, or linking up buyers and sellers, sucked liquidity out of the market, which caused it to spasm.

In years past, humans acted as market makers on the floor of the New York Stock exchange. That began changing about a decade ago, as computers and high-frequency traders pushed them out of business. Now, as one hedge fund executive recently put it, "automated trading strategies have nearly completely replaced traditional human market makers in many electronic markets."

That changes everything. Traditional human market makers are legally obligated to provide liquidity regardless of market volatility. High-frequency traders have no such duty, which can exacerbate market volatility when they back away and stop trading. "Many high-frequency traders are today's de facto market makers," Sen. Chuck Schumer said last year. "However, they are not subject to the legal obligations of market makers."

In short, unless there's a detailed plan to bring back official market makers, people have to be very careful what they wish for when talking about "instantly wiping out" high-frequency traders. Volatility might skyrocket.

But forget the stock market. Would a transaction tax discourage other risk-taking and clamp down on systemic risk posed by Wall Street banks? A recent paper by the International Monetary Fund is skeptical:

Though transactions costs may play a role in determining market cycles, they are clearly not a decisive factor. Bubbles and crashes are common in real estate markets, where transaction costs (including taxes) are extremely high compared to securities transaction costs, generally on the order of several percentage points.

I'm all for putting the kibosh on speculation that causes systemic risk and violent market disruptions. And I'm all for new taxes that force mega-institutions like Bank of America (NYS: BAC) , Citigroup (NYS: C) , JPMorgan Chase (NYS: JPM) , and raft of hedge funds to pay for the damage they've caused. But is a transaction tax the best way to do it? I have my doubts.

How about you?

At the time thisarticle was published Fool contributorMorgan Houselowns B of A preferred. Follow him on Twitter, where he goes by@TMFHousel.The Motley Fool owns shares of Citigroup, Bank of America, and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.