Democrats Take on Wall Street With Financial Transactions Tax

The House Democratic Party leadership made a remarkable step forward last week in putting out a proposal for a financial transactions tax (FTT). The proposal is part of a larger package which includes a substantial tax credit for workers, and also a limit on the tax deductibility of high CEO pay, but the FTT portion is the most remarkable.

There has long been interest in financial transactions taxes among progressive Democrats. The list of people who have proposed financial transactions taxes over the years includes Representatives Peter DeFazio and Keith Ellison, along with Senators Tom Harkin and Bernie Sanders.

But the proposal last week came from Representative Chris Van Hollen, who is part of the party's leadership. And Minority Leader Nancy Pelosi indicated that she also supports the proposal. This means that financial transactions taxes are now part of the national debate on tax and financial policy.

And there should be no mistake; this is a really big deal for the financial industry. The proposal outlined by Van Hollen is modeled after one being debated in the European Union. It would apply a tax of 0.1 percent on each stock trade and 0.01 percent on trades of derivatives like options, futures, and credit default swaps. The European Commission estimated that this rate structure would generate an amount of revenue equal to 0.4-0.5 percent of GDP. In the United States, this would be between $70 billion and $90 billion a year.

The best thing about this story is that almost all of the revenue would come from the financial industry. While the tax rate would be low even if borne by investors, research shows that trading volume will decline roughly in proportion to the increase in trading costs. This means that if the tax raises trading costs by 50 percent, we would expect trading volume to decline by roughly 50 percent. The amount that normal investors, for example people with 401(k)s, pay for trading will remain pretty much the same.

Investors care about what they spend on trading costs, not what they spend on trading taxes. In this case, the additional amount they spend on taxes is offset by a decline in the amount they spend on other trading costs (e.g commissions and fees to the industry), leaving their total costs unchanged. And since investors don't on average gain through trading (for every winner there is a loser), this means that the financial industry will bear almost the entire burden of the tax.

Needless to say, the industry will not be thrilled about this prospect. The cost to them of the FTT is almost certainly larger than all the provisions in Dodd-Frank put together. Enormous profits and massive paychecks have been earned in recent times through the proliferation of complex derivative instruments and the promotion of the rapid turnover of stock and other assets. This would all change with the FTT that Van Hollen is proposing.

To be clear, this is not a story of shutting down the financial industry. The financial industry plays a central role in sustaining a healthy economy. It provides the money families need to buy homes or start businesses. It also provides businesses with the capital they need to expand. But the financial sector has grown way beyond the size necessary to fill these purposes, with the core financial sector (investment banking and securities and commodities trading) expanding five-fold as a share of the economy since the 1970s.

Research from the Bank of International Settlements shows that a financial sector of this size is a drag on the economy. It pulls highly skilled workers away from productive sectors like computers and biotech. It also pulls capital away from smaller firms, as money goes into speculation rather than the expansion of rapidly growing businesses.

The Van Hollen proposal would raise the cost of trading stock and other financial instruments back to where to where it was 15-20 years ago. The United States had a large and dynamic capital market in 1995; it would have a large and dynamic capital market in 2015 if trading costs returned to their levels of twenty years ago.

The Democrats deserve a lot of credit for adopting this proposal. The financial industry is enormously powerful and will do everything it can to bury Van Hollen's plan before it gains any traction. Look for a slew of economic studies showing that a tax of 0.1 percent on stock trades will be the end of the economy as we know it. The reality is that it just means the end of speculative finance as they know it, and this is a very good thing.