The goal is lofty, audacious and of perfect soundbite length: Free college tuition for all, paid for exclusively by a “small” tax on “Wall Street speculators.”
There’s an old adage ‘if it sounds too good to be true, then it probably is.’ That saying is particularly applicable to the notion of a financial transaction tax, which some have embraced as a “wonderful and profound idea.” Nothing could be further from the truth.
The introduction of this long-debated levy in the U.S. will compromise our financial markets, which have been recognized as “the deepest and most liquid markets in the world.” Removing that competitive advantage and years of innovation—by increasing investor costs—is a profoundly bad idea that will result in many unintended consequences that would prove harmful to our economy.
In proposing the tax, presidential candidates Senator Bernie Sanders and former Governor Martin O’Malley have focused the debate on curbing high frequency trading. But make no mistake, it would have far-reaching effects and touch every investor. That’s because Principal Trading Firms using high frequency trading techniques now account for about half of overall exchange volume and have played an instrumental role in making markets more efficient for investors. Thanks to their technological capabilities, these firms are able to quote investors tighter prices to buy and sell stocks, which means they pay less to complete their orders. A loss of Principal Trading Firm activity will translate into higher costs for investors.
The proposed tax will apply to everyone in the trading ecosystem, including, ironically, the endowments that colleges and universities depend upon to fund their operations, financial aid and scholarships. The fact that it will also be paid by retail investors is one of the main reasons the Investment Company Institute, an industry association which represents the $16 trillion U.S. mutual fund industry, opposes the transaction tax. ICI says it “would raise the cost of trades that a fund makes for its portfolio and would depress fund returns.” The 2015 ICI Fact Book shows that households held 89 percent of mutual fund assets. That unfortunately means that Mom and Pop will be the ones forced to pony up.
Messrs. Sanders and O’Malley have undoubtedly stirred populist passions on this issue, proposing that a tax of 0.5% on trading is small. That figure doesn’t sound like much, but when you take into account that investors pay an average of $84 to buy one share of an S&P 500 company’s stock, this levy will actually amount to an average of $0.42 per share, paid by both buyers and sellers.
To calculate this charge on a per trade basis, let’s take the trading activity that took place on June 10, 2015 as a representative example. On that day, the NASDAQ had an average trade size of 158 shares, valued at $7,434.07. If the tax were in place, each buyer and seller would have been hit with a tax bill of $37.17 for the trade – four times greater than the $8.95 it would actually cost them to make the trade using discount brokerage Charles Schwab. For an industry that prides itself on reducing trading costs – the average retail commission charged per trade has fallen by $20 over the past decade – this tax basically rolls back the clock and eliminates many of the gains that have been made possible by market efficiency.
Historically, financial transaction taxes have a terrible track record. One of their biggest flaws is that they simply drive investors away from markets. A June analysis by the Tax Policy Center, a non-partisan joint venture between the Brookings Institution and the Urban Institute, found that when Sweden and France introduced such taxes in 1984 and 2012, respectively, trading volume in those countries declined significantly. In the former’s case, the tax “did lasting harm to the Swedish stock market,” the Washington, D.C. think tank said. Less trading activity means that stock inventories will thin out and “spreads,” or the price difference between a buyer and seller when negotiating a stock sale, will widen to account for this scarcity. In Canada, this very outcome occurred when regulators aimed such a fee at high frequency traders a few years ago. Spreads there increased by nine percent and retail investors saw their returns suffer.
Strong financial markets, venues that efficiently bring buyers and sellers together, drive business and economic growth. In the U.S., the Jumpstart Our Business Startups Act was passed mainly to foster job creation and improve emerging growth companies’ access to the public capital markets. For thinly-traded, small-cap companies, a financial transaction tax means less liquid markets and increases the likelihood that they will never explore such funding alternatives in the first place –that will stunt innovation and cause lasting economic damage.
While the prospect of a financial transaction tax sounds like a prudent measure, it’s actually the very definition of irresponsible regulation. Such a tax would inflict an unnecessary financial burden on retail investors, drive participants out of the marketplace and, as a result, fail to accomplish its original goal.
Affordable college for all is a noble pursuit, and undoubtedly our capital markets can play a beneficial role in making it happen, as they have already for millions of families. But looking to gain support and funding that goal by damaging capital markets that are the envy of the world, is reckless policy.