Financial Transaction Taxes Stifle Liquidity
When the federal deficit reaches levels the country has never before seen, politicians get excited about any possibility to raise revenues. A recent approach, one designed to reduce speculation while increasing revenue, is spreading around the world. The financial transaction tax.
Financial Transaction Tax on Paper
Before any real world economic modeling, a financial transaction tax makes perfect sense. Congress can pass a relatively small tax (they’re thinking about a .005% tax on foreign exchange transactions) and generate huge amounts of revenue. The idea is perhaps shortsighted, but again, it looks good on paper. A trillion dollars trades hands in a day on the market, so even if you took .1% of it you’d generate an extra $1 billion per year. Sweet! Not.
Financial Transaction Tax Goals
Legislators suggest that the financial transaction tax offers ends to two goals. First, the tax can be used to increase revenues. Second, the tax will help decrease speculation, a positive element of the market often misconstrued as a negative.
The tax will with all certainty increase revenues, however it will, in absolutely no shape or form, create better performing markets. You see, when you create a tax simply for moving money around, what you create are more illiquid markets. Assume that Congress were to pass a tax on trading that took .1% of all buy and sell orders. Investors would now be at a disadvantage, and would have to create trading models that produced at least a .1% return.
Well, only a very small percentage of the total transactions on the stock market actually create any serious revenue. Most trades are completed through a marketmaker who literally shaves pennies off hundreds of dollars several thousand times a day to make a profit. (See high frequency trading).
Less Liquidity
A finanical transaction tax will create a system in which a market maker has to change its trading models to make at least the amount of the tax on each trade. So, if a market maker was previously making an average of .3% per trade, it would have to increase its profit margins by 33% to cover a .1% percent tax…and that is just to break even.
A financial transaction tax would not decrease speculation, it would decrease the number of trades completed by middlemen. Removing middlemen means removing liquidity. The new .005% tax on foreign exchange trades is expected to reduce speculation by 14%. That 14% reduction represents a complete removal of all short term trades…those that produce liquidity in the marketplace.
Speculators are in the money for far more than .005%, and market makers are around for just around that figure. A .005% tax on the EURUSD pair equates to .6373 pips. Now, most market makers are in the business to earn 1 pip on a trade, so an additional .6373 pips is the equivalent of a 66% decrease in revenues for marketmakers. (The tax will probably be paid for by traders, or passed on through marketmakers, but the point stands) A trader looking for a 20 pip gain would now be at a disadvantage of 8.1865% instead of the 5% disadvantage before tax. Tell me that doesn’t make a big difference. That’s like playing an American Roulette wheel instead of a European Roulette wheel.
Man, we sure have some dumb legislators.
As you certainly well understand, politicians typically look into the future with a range of vision that barely goes beyond the end of their nose. They look at today, and grab onto an easy to absorb idea that will allow them to raise the most money while annoying the fewest voters. Since the overwhelming majority of voters don’t trade Forex, this is a no-brainer (pun intended!) for a politician.
The big thing that they always overlook is the immutable “Law of Unintended Consequences”. Needing to give the appearance of solving today’s problem, they simply don’t factor in the inevitable results of their actions.
You’re very kind when you call them “dumb legislators”. I can think of other terms of description.