December 7, 2011

About that renewed talk of taxing financial transactions

This op-ed was published on the website of the Washington Examiner on Dec. 7, 2011.

The congressional Joint Economic Committee held its “Joint Hearing on Tax Reform and the Tax Treatment of Financial Products” earlier this week.

The hearing came soon after the Section of Taxation of the American Bar Association (ABA) sent a letter to the Senate Committee on Finance and the House Committee on Ways and Means entitled “Options for Tax Reform Relating to Financial Transactions.”

Though the lengthy paper contained within the ABA’s letter does not attempt to examine the economics of Financial Transactions Taxes (FTT’s), it brings back discussion on a subject, which was last seriously advocated on Capitol Hill by Rep. Nancy Pelosi, the former speaker and current Democratic Minority Leader.

The hearing also came on the heels of a European Union proposal to tax financial transactions and will undoubtedly stir up some dormant talking points for U.S. legislators.

However, even at a time when fiscal consolidation is desperately needed, such taxes should never be seriously considered as a panacea, and here is why:

  • High transaction volumes provide liquidity necessary for price discovery.
  • Much of short-term transactions are done to hedge and mitigate risk.
  • An increase in transaction costs will increase short-term volatility.
  • People can easily circumvent an FTT and the tax will be cumbersome to structure.

Even FTT proponents must, at the very least, concede that the academic literature on the subject is totally ambiguous. A survey of 11 articles published between 1989 and 2010 shows that the literature is completely divided, with four articles arguing against FTT’s and three arguing in favor of them. The legitimacy of any policy taxing financial transactions would be absolutely undermined by this division.

In addition, revenue estimates from FTT’s range from $17 billion to $360 billion (in 2010 dollars). Though the low figure does not account for the large increase in trading volume since 1989, doing so still yields a very large gap in estimates.

This fact should prevent legislators from justifying the implementation of such policy by claiming that FTT’s will be a certain and stable revenue source.

Patrick Honohan and Sean Yoder put it best in their 2010 World Bank paper on the subject, Financial Transactions Tax: Panacea, Threat, or Damp Squib.

“Certainly not a panacea, and more likely a damp squib in terms both of revenue and efficiency gains (and perhaps more likely to result in efficiency losses), financial transactions taxes could be a threat to fiscal stability,” Honohan and Yoder wrote.

A threat to fiscal stability-the absolute last thing American solvency needs.

David Logan is an economist with the Tax Foundation.