photo by Ahmad Ardity
Current and former candidates for the Democratic presidential nomination have expressed support for a “financial transaction tax.” As election year tax policy promises go, it is not one worth losing sleep over – regardless of the naysayers’ doomsday predictions.
In the 2020 race, the financial transaction tax gained traction among candidates positioning themselves as moderates and those embracing the party’s left wing. Former presidential hopeful Michael Bloomberg jumped on the financial transaction tax bandwagon most recently in February. Sen. Bernie Sanders of Vermont expressed his support for a financial transaction tax as far back as his 2016 presidential run. Now-former candidates Sen. Elizabeth Warren, Pete Buttigieg and Andrew Yang were also in favor of the approach. Even former Vice President Joe Biden seems to be open to the idea.
The basic theory behind a financial transaction tax, sometimes abbreviated as “FTT,” is that every stock market transaction should kick a little back to Uncle Sam. The exact mechanisms proposed vary, but a plan introduced in the Senate in late 2019 suggests a basic framework. Every time someone sells a stock, bond or derivative, the government would impose a tax on the transaction. The details for derivatives are a little more complicated than for stocks and bonds. But overall, a financial transaction tax means the government gets a cut of every trade, maybe with a few exceptions such as initial public offerings.
Proposals vary, but the suggested tax level is usually low. Bloomberg, Warren, Buttigieg and Yang favored setting the tax at 0.1%. Sanders’ plan includes different rates for particular transactions, taxing stock trades at 0.5%, bond trades at 0.1% and derivative trades at 0.005%.
Predictably, some industry insiders have been quick to make dire forecasts for the potential results. The Investment Company Institute argued that most small investors use mutual funds, and they will face major cost increases because of this tax. The U.S. Chamber of Commerce claims it will hurt returns for individual investors and drive up the cost of home mortgages. The executive vice president for the U.S. Chamber’s Center for Capital Markets Competitiveness, Tom Quaadman, said in a statement, “A Financial Transaction Tax will increase the cost of capital, decrease investment, harm businesses and hurt Americans who are saving and investing.” Treasury Secretary Steven Mnuchin said at a hearing in December that he was “very concerned that [an FTT] would destroy our capital markets.” Other industry opponents assume the tax is a political nonstarter, and so have not taken the prospect seriously.
Despite this handwringing, a financial transaction tax is unlikely to change much for most Americans. There are a few reasons to think so.
First, the U.S. would not be alone in imposing a financial transaction tax. It would join the ranks of countries including the United Kingdom, France, Switzerland, Taiwan and Hong Kong. These countries are generally doing just fine. Hong Kong’s 0.1% tax on financial transactions, set at a level near the ones proposed here, has had no discernible negative effects, unless you view limiting high-frequency trades as a negative outcome. Taxing financial transactions is not a new, untested idea. It has not caused a meltdown in places that have implemented it. The odds it would reshape the entire U.S. economy for the worse are slim. This wouldn’t even be the first time the U.S. had tried such a tax – Congress repealed an older financial transaction tax in the 1960s.
Second, whatever amount the candidates expect this new tax will raise, it will almost certainly raise less. Warren and Buttigieg both estimated $800 billion; Sanders’ more ambitious plan is meant to raise $2.4 trillion, according to the candidate. But the tax itself will affect investor behavior and put a damper on trading to some degree. High-frequency traders, who make up a significant portion of daily trading volume, would have no choice but to change their approach in the face of a financial transaction tax. Such a tax will still raise money, and probably a significant amount. But we cannot know in advance how it will impact high-frequency traders, and the answer is likely to shape how much the tax raises in the long term.
This raises the third point: Is hampering high-frequency trading really all that bad? We tax all sorts of things that we think is in society’s interest to make more expensive: cigarettes, soda and alcohol, among others. High-frequency trading, unlike cigarettes, does not cause cancer. But it can still cause harm. For some supporters of financial transaction taxes, in fact, hampering this behavior is the tax’s main benefit. Economist Joseph Stiglitz wrote in 1989 that a financial transaction tax “is likely to increase the overall efficiency of the economy and may actually enhance the efficiency with which the stock market performs its most important roles.”
Some economists have suggested this tax might kill high-frequency trading outright, at least in its current form. Many financial transaction tax supporters argue that doing so could make the market less volatile for individual investors. Opponents say that high-frequency traders create liquidity and make the entire system function more smoothly. The debate about whether high-frequency trading adds value to the market as a whole is ongoing.
At Palisades Hudson, my colleagues and I encourage our clients not to trade too often. This is not only to avoid fees – after all, in the race to the bottom, trading commissions have fallen all the way to zero in some cases. But even when you don’t pay to trade, frequent trading almost always hurts more than it helps an individual investor. A tax that makes investors think twice about constantly trading their portfolios is not necessarily a bad thing.
Finally, investors shouldn’t worry about a financial transaction tax because the effect simply won’t be that large for most individuals saving for retirement or other long-term financial goals. Sanders aside, most discussions of a financial transaction tax assume a level of 0.1% or so. Even Sanders’ higher 0.5% proposal is equal to the tax already in place in the U.K. At the levels most investors trade, even that should not add up the way critics claim.
An example may illustrate the costs involved with a financial transaction tax: Say that a hypothetical client named Kate came to our firm with $1 million to invest, currently in cash. Investing it in almost any way will mean taking 0.1% off the top, upfront. We usually invest largely in mutual funds and exchange-traded funds, which means we will then need to consider how much trading the funds’ managers will do. This is a fund’s “turnover ratio.” A fund with a turnover of 100% changes all its underlying stocks once a year. As of February 2019, the average turnover for managed domestic stock funds was about 63%, according to Morningstar.
To make the math simple, let’s say we invest Kate’s whole portfolio in funds with a turnover of 100%. In the first year, she’ll owe an extra 0.1% in tax due to turnover. (While the mutual fund itself would pay the tax for these trades, the fund would pass that cost along to its shareholders.) That means, between turnover and her initial investment, she will have lost 0.2% of her investment – or $2,000. A single good day in the stock market can make that back, and a whole lot more.
In reality, for many investors the tax may mean even less. Many people are flocking to index funds, which often have turnover in the single digits and seldom over 20%. If your portfolio is managed using a long-term strategy – an approach we encourage our clients to take – your tax burden is likely to remain low. The tax may add up to 1%, 2% or more for investors who trade very frequently, but the financial impact will be much less for long-term investors.
In general, I believe that our government should figure out how much revenue it needs and adjust income taxes accordingly. But as ancillary taxes go, this one doesn’t strike me as especially burdensome unless you are making trades all day long – in which case, it is a good incentive to stop doing that. Based on what we know, the idea of a financial transaction tax simply isn’t worth worrying about for most ordinary investors.