The Progressive Fix

A Different Take on the Financial Transaction Tax

Having just joined the Progressive Policy Institute from a stint on Wall Street, I’d like to offer a different perspective on the financial transactions tax (FTT).

Last week, Lee Drutman argued in favor of an FTT, saying that a transaction tax modeled after the one our British friends have would raise much-needed funds. Writing in light of the past year’s economic crisis, Drutman also said that an FTT would “throw a little sand in the gears of the giant financial speculation casino.” While both raising revenue and reining in Wall Street are goals worth pursuing, I would argue that the FTT is a second-best solution.

According to Dean Baker of the Center for Economic and Policy Research, a proponent of the FTT, a Yankee equivalent of John Bull’s 0.25% transaction tax wouldn’t raise $100 billion — it would raise less than a third of that. You need to crank up the tax — to double the proposed amount on stocks and higher on other products — to get close to a hoped-for $100 billion in revenue.

Also, it’s worth pointing out that a transaction tax didn’t spare the British from any of last year’s financial crisis — they had housing crises, government bailouts, and bank nationalizations comparable to what we saw on this side of the Atlantic.

A transaction tax is simply too blunt an instrument. Pouring sand in the gears is not a way to slow a machine down — it’s a way to try to bring the machine to a halt. Trying to second-guess trader activity by taxing stocks and other securities at differing levels to generate sufficient revenue will only drive broker dealers to encourage trading in high-margin products to make up for the dead-weight loss of the tax. This would drive traders away from liquid products to illiquid ones, increasing systemic risk. This increased focus on complex structured products drains liquidity from the system, as we saw last fall.

A better solution is one along the lines in Sen. Chris Dodd’s (D-CT) proposed financial reform bill. In addition to heightened capital and leverage requirements for systemically significant, “too big to fail” banks, higher capital requirements and stricter leverage controls could be imposed on trading in complex financial instruments. This would drive Wall Street firms looking to goose returns through leverage from trading the complex products that contributed to last year’s crisis to more liquid — less systemically threatening — products.

Investors that would want to speculate on complex derivatives could still do so, providing they did it with their own money. And banks that wanted to sell those products could still do so, provided they had adequate capital to backstop those activities. Letting these properly priced incentives work their magic would allow the market to behave in a responsible manner. Revenue could then be generated from that market activity by taxing gains made by speculators at a rate in line with income tax rates.

This would achieve the goals the FTT sets out to do — rein in derivatives risk and raise revenues — in a way that leaves market forces free to be a driver of renewed growth in our economy. But I suspect the supporters of the FTT will want to have their say, and I look forward to hearing it.

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