• Taxing Financial Transactions

    The Obama Administration is looking for ideas in the area of taxing financial transactions. Ezra Klein asked for thoughts. Even though I haven’t read deeply into this area (*) I have an idea to share. I would not be at all surprised if it has already been proposed or considered by those more knowledgeable in this area than I am. Nevertheless, here goes:

    We already tax financial transactions in a way via short- and long-term capital gains, the cutoff between the two being one year. If a policy goal is to reduce high-frequency trading I have two ideas that build on the current tax framework: (1) Include a “very short” category with, say, a cutoff of a quarter year, or month (or whatever makes sense to the folks who really know this stuff). This very short category could have, though need not have, an even higher capital gain tax rate than the current short-term one does; (2) Eliminate the ability to write off short-term (or very short-term) capital losses. Ideas (1) and (2) need not be combined.

    A third idea is to remove the taxation exemption from otherwise tax preferred accounts (401(k)s, IRAs, 529s, etc.) but only for very short-term trades. I can already hear the howls on this one as it might be characterized as the first step down the slippery slope toward elimination of tax advantaged vehicles. Still, if we want to provide an incentive for buy-and-hold, we can’t ignore tax advantaged accounts, can we? High-frequency trading can be done under those vehicles so why should they be exempt?

    The point here is not to penalize everybody who wishes to participate in the market, but to make some (perhaps crude) distinction between types of market behavior. We already do this, as I said, so why not build on it?

    What do readers who know finance better than I do think? (TFB, Mike, others?)

    (*) This disclaimer serves as notice that this is a deviation from my M.O. You’ve been warned!

    Note: I added the paragraph about tax advantaged accounts in a later update to this post.

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    • At this point I’m still officially undecided in terms of whether I think the proposed tax is a good or bad idea.

      I’m obviously a buy & hold investor, so it won’t affect me much directly. And I quite like the idea of encouraging buy & hold investing.

      On the other hand, I think even buy & hold investors benefit significantly from the mostly-efficient nature of financial markets. And when we impose greater transaction costs, that efficiency is impeded.

      On another note, I’m opposed to the entire concept of using the tax code to induce certain behaviors. But that one’s obviously a lost cause at this point.

    • Hi,

      Taxing financial transactions is a terrible idea. Particularly equity transactions where little to no leverage has been employed. Most financial crises are caused by too much leverage and debt–not too much liquidity.

      I think the best argument against the transaction tax was made by Burton Malkiel (Princeton) and George Sauter (Vanguard) in the WSJ:

      http://online.wsj.com/article/SB10001424052748703558004574579903734883292.html

      Here, you have mostly buy-and-hold academics and market practitioners arguing that high-frequency trading has been beneficial to market participants. Additionally, they argue that the financial transactions tax will decrease liquidity (breadth and depth of the market), increase volatility, and increase spreads & transactions costs. These costs will ultimately be borne by non-high-frequency traders, mutual funds, individual investors, etc.

      It’s a bad idea and even the buy-and-hold advocates know it.

      Regards,
      ~a

    • Higher taxes will reduce US growth and are just one more reason for investors to move their money offshore, especially foreign investors. Why invest in the U.S. when your money is treated better elsewhere?