Naked Capitalism on Taxing Wall Street

Why It’s Absurd that America Doesn’t Tax Wall Street’s Transactions

Yves here. The post below from Paul Buchheit makes a persuasive layperson’s case for a financial transactions tax. There is an equally sound case to be made from a financial markets viewpoint.

The idea of a financial transactions tax started with James Tobin (they are often referred to as “Tobin taxes”). Before the US went off the Bretton Woods standard, exchange rates were fixed. Tobin recognized that the post-Bretton Woods world of floating currencies would encourage currency speculation which if it became excessive would produce undue volatility. Currency volatility is a Bad Thing because it makes it difficult to plan. In the old days, when Italy had the lira, if you an Italian businessman wanted to export to England, you’d need to see if you could earn enough money based on what you’d assume the sales price range would be in pounds. Obviously, you’d need to anticipate price movements within a certain range, but if prices were so variable that you couldn’t make a reasonable forecast of the range of expected pound/lira movements, you probably could not go ahead, since you’d be taking too much risk in gearing up the additional production and investing in marketing in England. To put it more simply, too much volatility hindered trade, and thus commerce. (And if you don’t think currency traders create volatility, I have a bridge I’d like to sell you. I’ve sat on currency desks and watched interbank traders push the markets around. And a very few were good enough to make money consistently doing it. Andy Kreiger was famed throughout the industry for his ability to fake out other traders (we have a short description of his ruses in ECONNED).

So the point of a transaction tax is to dampen volatility by increasing the cost of trading. It’s a deliberate “throw sand in the gears” strategy. Now why could that possibly be a good thing? Let us turn the mike over to Andrew Haldane, the director of financial stability at the Bank of England. From his speech The $100 billion question:

Tail risk within some systems is determined by God – in economist-speak, it is exogenous. Natural disasters, like earthquakes and floods, are examples of such tail risk. Although exogenous, even these events have been shown to occur more frequently than a normal distribution would imply. God’s distribution has fat tails.

Tail risk within financial systems is not determined by God but by man; it is not exogenous but endogenous. This has important implications for regulatory control. Finance theory tells us that risk brings return. So there are natural incentives within the financial system to generate tail risk and to avoid regulatory control. In the run-up to this crisis, examples of such risk-hunting and regulatory arbitrage were legion. They included escalating leverage, increased trading portfolios and the design of tail-heavy financial instruments…

Because tail risk is created not endowed, calibrating a capital ratio for all seasons is likely to be, quite literally, pointless – whatever today’s optimal regulatory point, risk incentives mean that tomorrow’s is sure to be different.

Now let us take this first observation from Haldane, that banks themselves generate risk, and combine it with a discussion in one of his later speeches:

In particular, we can draw on a framework developed a century after the introduction of limited liability – the contingent claims model of Nobel Laureate Robert Merton (1974). This tells us that the equity of a limited liability company can be valued as a call option on its assets, with a strike price equal to the value of its liabilities.

Figure 1 demonstrates this option-like payoff profile to holding a hypothetical bank’s equity. The beta of a firm is measure of how its value varies with the market as a whole. Arithmetically, the beta of a bank’s equity is the product of its leverage and the beta of its assets.11 So assuming an asset beta of 0.1 and a leverage ratio of 10, the bank’s equity beta will be equal to one. The returns on bank equity and the return on the market will then lie on a 45 degree line, provided returns are positive. When market returns are negative, however, returns on bank equity will not follow them south. Instead they will be capped by limited liability.

This asymmetric payoff schedule generates interesting incentives. The value of the equity option is enhanced by rises in the volatility of the bank’s assets. Why? Because volatility increases the upside return without affecting the downside risk. If banks seek to maximise shareholder value, they will seek bigger and riskier bets. Joint stock banking with limited liability puts ownership in the hands of a volatility junkie.

To put it simply, financial firms have huge incentives to generate volatility, which profits them at the expense of the real economy, and they have the means to do so. A transaction tax is one approach to making it less profitable for them to create volatility (Haldane has argued for prohibition, meaning an outright ban of unduly risky activities and products).

I have a minor quibble with the Buchheit piece. He argues, as many do, for both the socially desirable effects of a transaction tax (as in discouraging the real economy tax of excessive speculation) and its revenue generation. Tobin taxes are meant to discourage unwanted activity. Think of them as a tax on pollution. The fact that they’d also produce income is a positive side effect, not the main objective.

By Paul Buchheit, a professor with City Colleges of Chicago, founder of and co-founder of Global Initiative Chicago. He is the editor and main contributor to the forthcoming book, “American Wars: Illusions and Realities.” Cross posted from Alternet

The logic for the tax is indisputable:

1. Financial industry speculation devastated middle-class homeowner wealth.
2. U.S. investors pay zero tax on their speculative transactions.
3. The tax is easy to implement, and is very successful in other countries.

The emotional appeal reaches most of America:

Why should the rest of us pay up to 10% on the necessities of life while risky derivative purchases aren’t taxed at all?

Why should kids around the country lose their arts programs while trillions of dollars flow, untaxed, to Wall Street?

On July 8th, 2013, Chicago Political Economy Group (CPEG) member Bill Barclay and Illinois Green Party Chair Rich Whitney presented arguments for the Financial Transaction Tax (FTT) in front of the Illinois Pension Reform Committee. The video is available here (01:29:40), and the slideshow here. Much of the following derives from their work.

The Tax Works in Countries with the ‘Freest’ Economies

A good place to start is Singapore. Or Hong Kong or Switzerland. These are three of the top five countries on the Heritage Foundation’s Index of Economic Freedom, and they all have FTTs. Critics who might argue that non-FTT taxes are lower in Singapore and Hong Kong should look at World Bank and CIA World Factbook datasets, both of which show the U.S. with lower tax revenues as a percentage of GDP. The U.S. is clearly undertaxed across a wide range of taxes.

Unimaginable Amounts are Being Traded in the U.S., with Zero Tax

Unfortunately, in our country, discussions about pension reform and education and infrastructure usually lead to talk about further cutbacks, as if that were the only solution. But pension funds and schools lost money because of financial industry malfeasance. And yet the financial industry keeps surging ahead. The 2012 trading volume for the Chicago Mercantile Group (CME) alone was $806 trillion, about 12 times more than the entire world GDP. In 2011 it was over $1,000 trillion — that’s a mind-dizzying $1 quadrillion.

There’s no sales tax on all that, just a tiny administrative fee. We’ve had to look elsewhere for our education funds. As Whitney noted, “Our tax system taxes poverty far more than it taxes wealth.”

A Tiny Tax Would Pay the Entire 2013 Federal Education Budget

A bill sponsored by Illinois Representative Mary Flowers would impose a modest .01% tax on CME stock and derivative trades. It would not include transactions involving securities held in retirement or mutual fund accounts. With this little tax, at current trading levels, up to $80 billion would be realized annually. Chicago-area trading alone would pay the entire federal education bill.

It’s Easy to Administer — Especially for One of the Most Profitable Companies in America

What are the objections? Administrative cost and inconvenience? No, the FTT is easy to administer, and difficult to evade. Clearing houses already review all trades, and serve as collection agencies for transaction fees.

How about the threat of a move to another state or country to avoid new taxes? It’s hard to imagine that from the CME Group, made up of the Chicago Mercantile Exchange and the Chicago Board of Trade. From 2008 to 2010 the company had a profit margin higher than any of the top 100 companies in the nation.

Big Revenues, Little Risk

Objections to the FTT seem superficial in light of the two main benefits: (1) The massive revenue potential; and (2) the likelihood of limiting the speculative trading that contributed to the financial meltdown in 2008. Informed Americans are in agreement on this. The tax is simple and effective and fair and long-overdue, and obvious to everyone except the business-friendly members of Congress.


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