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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 (NYSE: 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 The Wall 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 (NYSE: BAC  ) , Citigroup (NYSE: C  ) , JPMorgan Chase (NYSE: 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? Let me know in the comments section below.

And if you'd like us to keep you updated on financial reform, simply shoot a blank email to

Fool contributor Morgan Housel owns 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.

Read/Post Comments (6) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 14, 2011, at 7:04 PM, neamakri wrote:

    I understand that some european markets are debating a transaction tax of 0.1% Personally I would like to see more, but why don't we just match the 0.1%? I really believe this will instill some stability into the market.

    I believe that High Frequency Traders (HFT's) are using their enormous financial clout to manipulate the market. Think about it; if you bought a big chunk of a company, the stock price would rise. Then sell it all back at a tiny profit. Repeat frequently.

    It is obvious that HFT's are not interested in actually owning any particular company, only whether they can manipulate its stock price.

    They play the market like a rigged casino where they make the rules. The 0.1% transaction tax will put a damper on this type of gambling and force HFT's to play with penny stocks. Also, matching Europe's tax will level the playing field.

  • Report this Comment On November 14, 2011, at 8:01 PM, iammainstreet wrote:

    Financial sector GDP has relatively increased because manufacturing has dropped from 22pc to 12pc over the same time. Numerous and far worse crashes have happened before high frequency trading and yet the market has increased 151 times over the last century.

    Financial transaction taxes are also astoundingly economically destructive. Some members of the EU are proposing an FTT. The EU Commission's 1200 page Impact Statement for FTT finds that Europe's annual GDP loss could be as high as 3.5pc or 430 billion euros removed annually from the European economy, and over a million jobs lost. That's 430 billion euros that would not receive a multitude of other types of taxation at around 50 percent. That's 215 billion euros in lost revenue annually. The FTT is estimated to produce 57 billion euros, to be removed annually from pensions and accounts. Important: Sweden's exact same, short-lived FTT produced 3 percent of estimated revenue, before all other revenue losses. This is a tax that could create an annual net loss of 158 billion euros, or more, which would require higher taxes elsewhere to make up for the losses the FTT creates.

  • Report this Comment On November 14, 2011, at 9:29 PM, rd80 wrote:

    "it would raise $350 billion in new tax revenue over the next nine years."

    Do you know if that estimate accounts for reductions in trading and for finance business that would move to other markets because of the tax?

    Unless all major exchange markets impose the same tax, this seems like a sure way to push business (and jobs and tax revenue) out of New York to Hong Kong, Singapore, etc., at least at the margins.

  • Report this Comment On November 15, 2011, at 6:52 AM, dbtheonly wrote:

    Rather than a percentage of value, a very small per share transaction fee would meet the need while having the advantage of eliminating the huge transactions for a fraction of a cent per share gain.

  • Report this Comment On November 15, 2011, at 3:55 PM, Hawmps wrote:


    A small per share fee would encourage HFTs to focus on higher dollar value shares and their influence on th market would be more focuses on those companies. The % fee is more uniform.

  • Report this Comment On November 15, 2011, at 5:44 PM, DJDynamicNC wrote:

    There should indeed be a plan in place to preserve liquidity, but even if the transaction tax fails to quell HFT, raising 350 billion dollars off the financial sector isn't such a bad idea in its own right.

    Shared sacrifice!

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