Recent Study on Financial Transaction Taxes Understates their Economic Harm

February 20, 2020

A recent article by Public Citizen, entitled “A Progressive Tax With Beneficial Effects,” estimates the impact that a 0.1 percent Financial Transaction Tax (FTT) such as the proposed Wall Street Tax Act would have on the retirement accounts of Americans. The author finds that an FTT would be progressive, have a modest impact on top earners, and could save families money by reducing cost-generating trades.

Public Citizen is right that an FTT would be progressive. However, the study’s approach may overstate the progressivity of the tax while understating the burden to all income groups. Furthermore, it is highly unlikely that an FTT would save families money.

FTTs levy a tax on each instance of the buying and selling of financial assets, such as stocks. For example, an investor selling an asset worth $1,000 would be charged $1 on the transaction under a 0.1 percent FTT.

FTTs have a larger impact on assets that turn over at high levels. Mutual fund turnover is the rate at which mutual funds trade their assets. For example, a mutual fund with an annual turnover of 50 percent would buy and sell assets worth half of the fund’s total portfolio value in a given year. Those transactions incur fees, which mutual funds pass to their investors. The Public Citizen study uses an average annual turnover of 32 percent to estimate the costs that would be passed down to investors by mutual funds. The study calculates the additional average annual costs from a 0.1 percent FTT to range from $4 for the bottom 20 percent of earners to $155 for the top 10 percent.

As Public Citizen notes, an FTT would also increase bid-ask spreads, which would further increase costs across all income tiers. This spread is the difference between the price an investor can sell for a given security and the price where that security could immediately be purchased.

Public Citizen characterizes the potential increase to bid-ask spreads as “modest.” However, that is not safe to assume. France’s 0.2 percent FTT on equities resulted in an increase in bid-ask spreads of 75 basis points, or almost four times the FTT rate. The exact increase in spreads due to a 0.1 percent FTT would depend on the tax design and the highly complicated and unpredictable behavioral response of the market. In any case, the effect could be substantial, imposing greater costs on taxpayers.

Much like the explicit costs of the tax, the implicit costs of increased bid-ask spreads would be borne predominantly by higher earners. The study’s results are therefore a reasonable representation of the shape of the distribution of the burden of an FTT due to transaction costs, although the results may understate the magnitude of transaction costs across all income groups.

The Public Citizen study also does not mention the various indirect ways in which FTTs affect taxpayers. In addition to increasing transaction costs, an FTT would decrease asset prices. This effect would predominantly impact the wealthy who disproportionately hold financial assets, but all investors’ portfolios would be negatively affected, including middle-class taxpayers.

An FTT such as the Wall Street Tax Act would lose some of its progressivity because it would increase the cost of consumer goods. Producers of goods use certain financial instruments to reduce risk. An FTT would increase the cost of trading those instruments, which would be passed on to consumers in the form of higher prices.

Public Citizen suggests that the resulting increase in transaction costs from an FTT could decrease turnover in mutual funds and save money for mutual fund investors. A decline in trading volume in response to an FTT is one of the key problems with the tax, as this  reduces the revenue an FTT would raise.

An FTT would reduce mutual fund turnover, as Public Citizen argues. Under an FTT, mutual fund managers would decrease the amount of transactions they make, offsetting some of the increase in the transaction costs that are passed to investors. However, the theory that turnover in mutual funds would drop so much that it would save investors money is not supported by the data.

The study references an International Monetary Fund (IMF) paper which compiles trading elasticities in various markets. Trading elasticities measure how much trading volume falls in response to an increase in transaction costs created by the tax. Public Citizen argues that because the magnitude of many of the elasticities studied is greater than 1, the reduction in mutual fund trading volume could be greater than the increase in transaction costs per trade, resulting in a net decrease in transaction costs. The original studies which calculated these trading elasticities took place between 1992 and 2007. Given the dynamic nature of the financial markets, all of these studies are outdated. Many of the elasticities describe trading responses in markets that United States mutual funds are unlikely to participate in (for instance, the Taiwanese futures market or the U.S. soybean futures market), making the elasticities unsuitable for estimating how mutual funds would react in the U.S.

It is possible that the trading elasticities compiled in the IMF paper are nonetheless similar in magnitude to the elasticities of the securities that mutual funds today might trade. However, these elasticities describe the sensitivity of an entire market in response to a change in transaction costs, not the sensitivity of mutual funds specifically.

Because an FTT is levied each time an asset is traded, it discourages frequent trading. High-frequency traders would have the most drastic response to an FTT, as their strategies consist of many low-profit trades that may become unprofitable. In comparison to high-frequency traders and certain other financial institutions, mutual funds (which focus on longer-term trades) would exhibit a far milder decline in trading volume under an FTT.

“A Progressive Tax With Beneficial Effects” accurately argues that FTTs are progressive, but the study understates the potential downsides associated with the tax. In addition to the concerns highlighted above, FTTs are unreliable sources of revenue and can increase risky financial activities. When looking to address income inequality and raise revenue, lawmakers should look to alternatives to this complicated and distortive tax. 

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