Financial Transactions Are A Very Poor Tax Base

January 14, 2015

One particularly salient feature of the Representative Chris Van Hollen’s new tax plan – a feature that is, frankly, not so good – is the 0.1% financial transaction tax.

Simply put, financial transactions are a very poor tax base. For one thing, it results in “pyramiding:” taxing the same economic activity many times. For another, economists generally think of trades as highly-valuable activity that benefits both parties, given that they both agreed to the deal. Taxing trade itself results in a kind of “lock-in” effect where people hold on to the things they have, whether or not they’re the best people to actually be holding on to them.

People need to make trades for a variety of reasons. For example, they may need to cash out some money for emergencies. They may need to rebalance their portfolios to minimize risk. Allowing people to do these things is a real economic good that people should be allowed to take advantage of.

But even beyond these private reasons people may need to trade their assets, trades produce a social good as well, a good that economists call liquidity. This is a concept mostly discussed by economists and professional investors, but it’s actually very apparent in everyday life too.

For example, imagine that you’re interested in a local artist, whose paintings have started to draw a lot of positive attention. The artist’s paintings are relatively hard to come by, especially because she’s still up-and-coming and many of her works are on display in homes, businesses, and museums – and not for sale. But eventually you manage to buy a painting from someone who already has one; because these are hard to find, there simply weren’t many on the market, and you had to purchase it at a somewhat-inflated price.

Then imagine you have to move unexpectedly to a smaller place in a new city, and you no longer have space for the painting. Because the artist is still relatively little-known, you struggle to find someone interested in the work. You take a few days to find a buyer, and sell at a discounted price in order to get the deal done quickly. You lose money from purchase to sale, not because the artist’s work truly changed in value, but simply because it was hard to find someone to make a deal with.

This is the cost of a market with few buyers and sellers. In contrast, imagine doing the same with, say, bonds issued by state governments. Those are things one can buy and sell easily, because they are such a huge market – people know their states and their state governments, and these bonds get regularly traded all the time. The result is that these aren’t hard to buy or sell at all, and everyone fairly gets approximately the same price at any given time.

This is a massive virtue, one that cannot be dismissed lightly. As you can see from the example of the painting, we miss it a great deal once it’s gone.

In a way, one should sometimes be most wary of taxes with a very, very, very low rate. It suggests a certain hesitance on the part of the policymaker, as if he knows he’s playing with something potentially very damaging. Let’s keep financial transactions firmly in the realm of the hypothetical.


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