Impose a Tax on Financial Transactions

Background

The United States is home to large financial markets with a large amount of daily trading. In June 2018, the total dollar value of U.S. stocks was roughly $30 trillion, and the value of outstanding bond market debt was about $42 trillion. More than $1 trillion in stocks and bonds—collectively referred to as securities—is traded on a typical business day, including about $300 billion in stock and over $800 billion in debt (which is mostly concentrated in Treasury securities). In addition, trillions of dollars in derivatives (contracts requiring one or more payments that are calculated by reference to the change in an observable variable), measured at their notional value (the total amount of the variable referenced by the derivative), are traded every business day. Those transactions may affect the taxes of individuals who engage in them, depending on the gain or loss those individuals realize; however, there is currently no per-transaction tax imposed under U.S. federal tax law. (The Securities and Exchange Commission charges a very small fee—generally 0.0013 percent—on most transactions to recover its regulatory costs; in 2018, those transaction fees totaled about $2 billion.)

Option

This option would impose a tax on the purchase of most securities and on transactions involving derivatives. For purchases of stocks, bonds, and other debt obligations, the tax generally would be 0.1 percent of the value of the security. For purchases of derivatives, the tax would be 0.1 percent of all payments actually made under the terms of the derivative contract, including the price paid when the contract was written, any periodic payments, and any amount to be paid when the contract expires. (Such payments are generally just a small fraction of the derivatives' notional value.) Trading costs for high-frequency traders tend to be very low—in many cases less than 0.1 percent of the value of the securities traded—so this option would generate a notable increase in trading costs for them.

The tax would not apply to the initial issuance of stock or debt securities, transactions of debt obligations with fixed maturities of no more than 100 days, or currency transactions (although transactions involving currency derivatives would be taxed). The tax would be imposed on transactions that occurred within the United States and on transactions that took place outside of the country and involved at least one U.S. taxpayer (whether a corporation, partnership, citizen, or resident).

The option would be effective a year later than nearly all of the other revenue options in this volume, so the tax would apply to transactions occurring after December 31, 2019. That delay would provide the government and firms sufficient time to develop and implement the new reporting systems that would be necessary to collect the tax.

Effects on the Budget

This option would increase revenues by $777 billion from 2019 through 2028, according to an estimate by the staff of the Joint Committee on Taxation (JCT). The tax on financial transactions would reduce taxable business and individual income. The resulting reduction in income and payroll tax receipts would partially offset the revenues generated by the tax. The estimate for the option reflects that income and payroll tax offset.

The estimate accounts for several effects that would reduce the revenues raised by the transaction tax. The option would lead to a loss in revenues in 2019 because the transaction tax would immediately lower the value of financial assets. That reduction in the value of financial assets would cause an ongoing reduction in capital gains. In addition, JCT's estimate reflects the expectation that financial transactions would be underreported until 2022, when all reporting systems could be expected to be in place. Revenues would be lower if the implementation of the option had to be phased in because of delays in developing the new reporting systems.

The additional revenues generated by the option would depend significantly on the extent to which the number of transactions subject to the tax declined in response to the policy. The higher the tax rate was set, the greater the amount by which transactions would decline. For that reason, doubling the tax rate would not double the amount raised by the option. (Similarly, cutting the tax rate in half would lead to less than a 50 percent decline in the amount of revenues raised.) With even higher tax rates, revenues could actually fall, for two reasons. First, the higher the tax rate was set, the larger would be the indirect loss in revenues from the drop in asset values and, therefore, the loss in revenues from the taxation of capital gains. Second, a higher tax rate would reduce the revenues generated by the financial transaction tax once the percentage by which the transactions decreased exceeded the percentage by which the tax rate increased.

The estimate for the option is uncertain for two key reasons. The estimate relies on the Congressional Budget Office's projections of the economy and market activity over the next decade, which are inherently uncertain. A bigger source of uncertainty, however, is how much transactions would drop in response to a tax. If the response was smaller than expected, the tax would raise more revenues than estimated here.

Other Effects

One argument in favor of a tax on financial transactions is that it would significantly reduce the amount of short-term speculation and computer-assisted high-frequency trading that currently takes place and direct the resources dedicated to those activities to more productive uses. Some high-frequency trading involves speculation that can destabilize markets, increase volatility, and lead to disruptive events, such as the October 1987 stock market crash and the more recent "flash crash" that occurred when the stock market temporarily plunged on May 6, 2010. Although neither of those events had significant effects on the general economy, the potential exists for negative spillovers from future events.

A disadvantage of the option is that the tax would discourage all short-term trading, not just speculation—including some transactions by well-informed traders that stabilize markets and help establish efficient prices that reflect more information about the fundamental value of assets. Empirical evidence suggests that, on balance, a transaction tax could make asset prices less stable. In particular, a number of studies have concluded that higher transaction costs lead to more, rather than less, volatility in prices. (However, much of that evidence is from studies conducted before the rise of high-frequency trading, which now accounts for a significant share of trading in the stock market.)

The tax could also have a number of negative effects on the economy stemming from its effects on asset prices, the cost of capital for firms, and the frequency of trading. Traders and investors would seek to recoup the cost of trading by raising the return they required on financial assets, thereby lowering the prices of those assets. The tax would be small relative to the returns that investors with long-term horizons could earn, so the effect on asset prices would be partly mitigated if traders and investors reduced the frequency of their trading—but less frequent trading would lower liquidity and reduce the amount of information reflected in prices. Consequently, investment could decline (even though higher tax revenues would lower federal borrowing and thus increase the funds available for investment) because of increases in the cost of issuing debt and equity securities that would be subject to the tax and potential negative effects on derivatives trading, which could make it more difficult to efficiently distribute risk in the economy. The cost to the Treasury of issuing federal debt could increase because of the increase in trading costs and the reduction in liquidity. Household wealth would decline with the reduction in asset prices, which would lower consumption.

In addition, traders would have an incentive to reduce the taxes they owed, either by developing alternative securities not subject to the transaction tax or by moving their trading out of the country (although offshore trades by U.S. taxpayers would be taxed). Such effects would be mitigated if other countries enacted financial transaction taxes. Several members of the European Union have such taxes, and since 2011, members have been negotiating whether to implement a common system of transaction taxes.