The Financial Crisis of 2008 demonstrated that instability and risk were built into the unfettered financial markets in the United States and around the world. Since the financial meltdown and the recession that followed, there has been heightened interest in Financial Transactions Taxes (FTTs) as a way to raise revenue while curbing the excesses of the financial sector.
FTTs are taxes on a nation’s monetary transactions in financial markets like securities trading (shares of stocks and bonds). In his Bernard L. Schwartz Rediscovering Government Initiative at The Century Foundation report, “Financial Transactions Taxes: Potential Revenue and Economic Implications,” co-director of the Center for Economic and Policy Research (CEPR) Dean Baker assesses the impact that an FTT would have on government revenue and the behavior of the financial sector. He notes that an FTT could also fund free public higher education, federal infrastructure projects, and universal pre-K.
Here are some of the impacts and implications that an FTT could have on the funding of government programs, the behavior of the financial sector, and the U.S. economy as a whole.
Revenue Raising Potential
Baker estimates that about $120 billion could be raised in the first year of the tax, with an average of $105 billion raised per year. This falls in the middle of other estimates by economists that range from $30 billion per year to $580 billion per year. Baker estimates this revenue generating potential via calculations based on current trading volume and a tax rates of 0.2 percent on stock trades, 0.1 percent on bond trades and 0.002 percent tax on the nominal value of derivative trades. After taking into account the eventual reduction in trading volume that the FTT would cause, Baker finds that the average annual revenue from the tax would be in the $105 billion dollar range. The higher the elasticity, the larger the reduction in trade volume after the tax is implemented. Lower revenue generation is also associated with higher elasticities. (View a table of Baker’s revenue projections based on elasticities in his report here.)
Reining in the Financial Sector
The financial industry would bear the brunt of an FTT. According to Baker, because of the elasticity of financial transactions, the financial sector would not pass on the cost of the tax to individual holders of shares, pension funds, and other investors. Elasticity is a way to measure the response of quantity demanded (or supplied) to changes in price.
With trades in financial markets, elasticity is the ratio of the change in trading to the change in the cost of a trade. If the elasticity of a stock is one, it means that a 5 percent increase in its trading cost would lead to a 5 percent reduction in the trading of that stock. Because the elasticity of trading volume in financial markets with respect to price is high (elasticities of one or greater), the tax will reduce unnecessary trades that will have little to no impact on the ability of financial markets to allocate capital effectively.
In other words, the reduction in wasteful trading volume will reduce costs for end users more than the tax would increase them.
In fact, high elasticities would imply that end users will be spending less on trading than they were before the tax was implemented, as the tax would reduce trading volume and trading expenses more than the tax increase itself. Financial actors will reduce their trading volume because of the tax. In other words, the reduction in wasteful trading volume will reduce costs for end users more than the tax would increase them.
Trucking as a Metaphor of The Growth of Finance
Baker employs an instructive metaphor of truck drivers delivering goods on roads throughout the country to demonstrate the effect of an FTT. Consider a group of trucking companies that are taking elongated routes to stores and shops in order to deliver goods at a higher price, billing end users for the extra mileage. They have expanded as an industry and exercise this market power through elongated routes, but not have not provided additional benefits in the form of faster deliveries.
This is clearly a waste of time and money for end users, who see no benefit to the scenic routes the truckers are taking to their shops; but the trucking companies are getting paid by the mile, so they extend routes as far as possible to increase revenue. The government decides to monitor truckers to make sure they take direct routes, reducing the waste from excessive mileage.
Financial markets operate in a similarly to trucking and other sectors that deliver immediate goods and services. They allocate (“deliver”) money and capital in a global economy that depends on money flowing to firms and users at the right place, the right time, and in the right amount. An FTT would be analogous to the trucker monitors, curbing the unnecessary trades that only benefit people within the financial sector without reducing the efficient allocation of capital. Based on this elasticity analysis, an FTT would not interfere with the productive use of the financial industry, which had been growing steadily since the mid 1970s. At its peak in 2006, the financial services sector contributed 8.3 percent to GDP, when in 1980 is only composed 4.9 percent to GDP.
Examples to Follow, Current International Efforts
There have been some examples of FTTs throughout history, including the stamp duty levied on shares sold on the London Stock Exchange that has been in existence since 1694. Most shares bought and sold at the London Stock Exchange carry a tax of 0.5 percent per trade. This tax raises about 0.2 percent of the United Kingdom’s GDP on average. That percentage of GDP would be the equivalent of $36 billion in the United States in 2016. Hong Kong raised 2.1 percent of its GDP through financial transactions taxes in 2008. Japan had a similar tax on trades until the early 90s that raised about one percent of GDP. The EU has an FTT plan in the works based on a proposal from 2013, but it has since stalled in the EU Council of Ministers, as several nations have reservations about the tax. France is ahead of the game, imposing an FTT of 0.2 percent on equity trades. Given the international push for FTTs in various financial markets and the history of FTTs around the world, such a tax in the United States is a viable policy choice in the near future, as it has both the regulatory effect of reining in financial trading and a revenue generating potential that could be used to supplement social programs.
What Could It Pay For?
With a revenue generating potential of about $100 billion annually, FTTs could be used to pay for a variety of social programs. Baker highlights its ability to fund free higher education, in the vein of Secretary Clinton and Senator Sanders’ proposals. With soaring student debt and college costs, the revenue generated from an FTT could defray the cost of higher education for students in working and middle class families. Making public colleges tuition free via the revenue generated by the FTT could also be a politically feasible arrangement given the right conditions. However, mechanisms would need to be put in place in order restrict the cost of public higher education. If costs continue to soar, even the large amounts of money raised through the FTT will not be enough to ensure affordable public higher education.
With soaring student debt and college costs, the revenue generated from an FTT could defray the cost of higher education for students in working and middle class families.
The $105.5 billion a year revenue projection that Baker estimates could be spent elsewhere. It could be used to supplement federal spending on infrastructure. It could fund President Obama’s Preschool for All Initiative fifteen times over, meaning an FTT could fund several programs at once if Congress chose to designate the revenue for multiple initiatives. Universal child allowances or universal child care funding are also robust progressive policies that could be funded via the FTT. Transferring resources from the financial sector to any of these policy areas would be a far more productive use of money that would otherwise contribute to financial waste or speculation.
Impact on the Economy and Inequality
Although the FTT is not a universal panacea for income inequality and economic disparity, it could be part of a larger policy initiative designed to rein in the financial sector while simultaneously curbing the economic inequality that has characterized the U.S. economy in recent decades. Many of the highest earners in the economy derive most of their income from the financial sector. If the FTT helps to downsize the industry that has often fast-tracked the growth of economic inequality, it could play a role in reducing that inequality (see figure below).
The FTT would not be able to reduce financial instability or destabilizing speculation on its own, but it also would not destabilize markets. We have seen that low trading costs and high trading volumes correspond with unexplained swings in prices; and since an FTT is designed to increase trading costs while reducing trading volumes, we do not need to worry about a destabilizing effect. The tax could also address the short-term profit motive that characterizes many financial markets, encouraging better management practices among financial firms. This would benefit many end users in financial markets, particularly those who depend on the long-term performance of financial products for pensions or other retirement funds.