Sunday, January 1, 2012

Time to consider financial transactions tax

Vijay K. Mathur

Published in Standard-Examiner, Ogden, UT, December 9, 2011

Financial transactions are a transfer of funds from people who are savers-lenders, to people who are borrowers-consumers or investors and financial markets, such as bonds, stocks, or foreign exchange, channel those funds. Financial intermediaries, such as banks, savings and loan institutions, insurance companies, pension funds, and mutual funds, facilitate financial transactions in financial markets. They enable small and large savers and lenders to lend their funds to those who need those funds at reasonable transactions costs, with ability to earn reasonable returns based upon their tolerance and preferences for risk. Financial intermediaries decrease costs of financial transactions due to economies of scale.

Sen. Tom Harkin, D-Iowa, and Rep. Peter DeFazio, D-Ore., have introduced legislation that proposes to levy a 0.03 percent financial transactions tax (FTT). The tax will be on transactions on previously issued securities. For example, if you buy $100 worth of previously issued stocks or bonds, the tax will be 3 cents. According to Dean Baker, Center for Economic and Policy Studies, the tax may raise more than $100 billion per year. The tax, especially on short-term transactions, will tend to reduce volatility in financial markets. Competition among financial intermediaries will prevent them from passing most of the tax burden on borrowers. One can think of FTT as a sales tax on financial transactions.

Financial services have acquired increasing importance in the U.S. private industrial sector and in the economy. Federal Reserve Board data show that total private credit market borrowing/lending was about $3.7 trillion (92 percent of all borrowing/lending) in 2006, before the financial meltdown in 2008. Bureau of Economic Analysis data show that value added growth in financial and insurance services was 6.7 percent when average growth of value added in private industries was 3 percent in 2006; this industry contributed 20 percent to the growth in Gross Domestic Product. In 2009, total private industry growth in value added was -3.0 percent while finance and insurance grew at the rate of 6.1 percent.

John Maynard Keynes advocated the FTT in 1936 to curb excessive speculations on Wall Street. The U.S. used the FTT from 1914 to 1966, and the idea was further revived in 1978 when Nobel Price winner economist James Tobin proposed a tax on short-term foreign currency transactions to stem speculation in the foreign exchange market. A similar problem exists in financial markets with high frequency trading. High frequency trading (increasing at a rapid rate) involves trading where computers are programmed to buy and sell securities when there is even a slight variation in security prices. When millions of securities are traded in an instant automatically without any change in economic fundamentals, it makes long-term business planning risky. Thus, increase in risk increases cost of capital (not financial capital) and thus investment in machinery, tools and factories that contribute to economic growth.

Volatility in bonds and stocks also affects consumption plans due to the wealth effect. For example, when the stock market is very volatile, it becomes riskier to plan ahead on consumption spending, especially for durable goods. This affects economic growth. In addition, when we impose a sales tax on transactions of many goods, the absence of a financial tax amounts to a subsidy to the financial sector, because sales tax on other goods makes those goods relatively more expensive than financial transactions. The financial transactions tax will level the playing field and will make all financial transactions more transparent. Also, there is no economic justification for giving a favorable tax treatment to corporate bonds (debt capital) as opposed to stocks (equity capital). The tax subsidy to bonds is one reason for the increased indebtedness and the financial meltdown in 2008.

Some have claimed that the tax will drive financial businesses away from the U.S. First, as CEPS suggests, we should follow the example of U.K. in levying the tax on trades of firms that are incorporated in the US. Secondly, the tax proposed in Sen. Harkin's and Rep. DeFazio's

CEPS reports that U.K. has a stamp duty of 0.5 percent on trades made on the London Stock Exchange, and London remains a thriving financial hub in the world. Many other countries have a variant of FTT. Germany and France are spearheading a campaign for a 0.1 percent FTT in the European Union, a much higher tax than 0.03 percent proposed by Sen. Harkin and Rep. DeFazio.

Conservatives should join the Democrats in Congress in passing this bill because this tax not only levels the playing field but also reduces volatility in financial markets. Since we are interested in stimulating growth, such a tax will reduce speculation, volatility and uncertainty in asset prices, stimulate investment and consumption for the long run, thus creating more stability in the economy.

Mathur is former chair and professor of economics and is now professor emeritus, Economics Department, Cleveland State University, Cleveland, Ohio. He writes original blogs for the Standard-Examiner at

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