Taxing Trades: Good Idea or Bad Idea?

There's a simple tax that could solve the fiscal cliff, writes Ralph Nader. He proposes a financial-transaction tax that he brands a "speculation tax," which would require you to pay fractions of a cent for each dollar traded. Is this a good idea that would curb speculation while giving the government a more balanced budget? Or is this an outrageous burden for investors to bear?

Breaking it down
Nader uses the example of a 0.25% tax for each financial transaction, which amounts to $2.50 on every $1,000 traded. Given that level of taxation and no reduction in trading volume, the government would take in about $350 billion each year in revenue. If the volume of transactions were cut in half, as investors might alter trading behavior given the tax, the tax revenue would also be cut in half to $175 billion.

For reference, the 2001 and 2003 tax cuts that are a part of the fiscal cliff cost the government $254 billion in revenue, therefore such a transaction tax could offset these tax cuts, depending on how trading volume changes.

Should the transaction tax be one of the steps toward a more balanced budget?

Pros
Adding a transaction tax would create a disincentive for high-frequency trading and other short-term strategies. After all, some of the pennies these algorithms chase would need to go to the government, making it a less profitable venture. High-frequency trading itself is controversial. Proponents say it makes the market more liquid -- though sometimes too liquid, as it can cause drastic swings in prices and balance sheets when glitches take over. For example, Knight Capital (NYSE: KCG  ) famously lost $10 million per minute as its computers went haywire at the beginning of August, tallying up more than $400 million and forcing the company to look for immediate outside capital.

Such a disincentive on frequent trading could put the focus on long-term investing and move the market's focus from the next quarter to the next year or next decade. In an environment where short-term results are less important, companies can invest in multiyear projects that could reap rewards for both investors and society. Amazon.com  (NASDAQ: AMZN  ) notably forgoes profit and instead funnels any potential profit right back into building out its infrastructure, products, and services. It confuses many investors and analysts with its incredible P/E ratio, yet it's up more than 45% this year, compared to the S&P500's  (SNPINDEX: ^GSPC  ) rise of about 9%.

Transaction tax proponents also point to a past-transaction tax that used to be levied in the U.S. to quell fears of any negative consequences. Starting in 1914, there was a 0.02% tax on stock sales, which rose to 0.04% in 1934 before being repealed in 1966. Even with this transaction tax, America continued to grow and become a world power.

Cons
Even though there used to be a transaction tax, the newly proposed tax is multiples higher than the old one. Additionally, trading is a much bigger business now than it was before 1966. Therefore the potential negative effects of such a tax are unknown, but let's look at a few possibilities.

Given a tax on buying and selling securities, trading volume could plummet while traders find loopholes. In the global market, investors can easily move to foreign markets to conduct trades. As trades go overseas, the projected tax revenue falls, and the tax just complicates investing for retail investors.

According to a RealClearMarkets article, the United Kingdom has a 0.5% tax on securities transactions, but through a special exemption, traders avoid the tax through investing in derivatives of stocks without actually owning the shares. Japan implemented a similar tax in 1987 that was repealed in 1993 after trading volume dropped 80% (although this also corresponds to the bursting of Japan's property bubble). Sweden tried the same, but "the tax raised less than 5% of projected amounts, as transactions moved to London."

If traders can't find loopholes and don't move overseas, then some speculate the extra cost of business will be reflected in stock prices; that is, because the tax will have to be paid, the value of the stock will decline to offset that cost.

Other solutions
While the two sides argue about this transaction tax, others propose different spins on a potential tax. Instead of taxing based on the number of dollars traded, the government could tax based on number of transactions. Alternatively, it could tax based on how long shares have been held.

Companies themselves have incentivized long-term investing with "loyalty shares." Both Lafarge  (NASDAQOTH: LFRGY  ) and L'Oreal  (NASDAQOTH: LRLCY  ) offer a 10% higher dividend for those who have held their shares for at least two years.

These solutions mix the objectives of limiting speculation and increasing government revenue, making the arguments for each option much more complicated as the discussion turns to the merits of quick-trading computers and whether the government should be looking for new sources of revenue or cutting expenses. A transaction tax could help fund the government, but it comes with its own issues.

High-frequency trading may earn pennies on each trade, but for those of us without supercomputers and proprietary algorithms, the best approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some wealth-building strategies every investor should be aware of. Click here now to keep reading.


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  • Report this Comment On December 03, 2012, at 1:46 PM, TMFCatoMinor wrote:

    Great take on an important issue. I think the US is a bit more protected from losing traders to the British exchange than Sweden is, given the size of our market, but any attempted transaction tax would probably have to be a multi-lateral agreement to prevent capital flight.

  • Report this Comment On December 03, 2012, at 2:44 PM, iammainstreet wrote:

    World gone mad: It's very important to tax investors to discourage investing and create more incentives to take on more debt to create more crises. I can see how investing in Google and Apple created the financial crisis though, LoL.

    It's not just a tax on investors:

    IMF's FTT Final Report For The G-20, June 2010, "Its real burden may fall largely on final consumers rather than, as often seems to be supposed, earnings in the financial sector. Because it is levied on every transaction, the cumulative, ‘cascading’ effects of an FTT—tax being charged on values that reflect the payment of tax at earlier stages—can be significant and non-transparent."

    $350 billion? No. Revenue will be negative:

    Proposed EU trading tax. UK Parliament Economic Sub-Committee of the House of Lords, "The FTT is likely to induce a loss in GDP between five and 20 times larger than the revenues raised from the tax."

    UK Parliament European Scrutiny Committee citing the EU Commission's FTT Impact Assessment, before including negative relocation effects, "a 3.43% fall in EU GDP equates to a fall in economic output worth €421 (£362) billion and a 0.34% fall in employment equates to a loss of 812,000 jobs."

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