Why a Financial Transactions Tax Makes Sense

Along with legislation to break up big banks, support is growing for another way to stabilize the financial system: a transactions tax.

The idea is to levy a small tax — a fraction of one percent, say — on securities trading. In theory, that would deter reckless speculation by raising the cost of spinning the roulette wheel. It would also let governments raise revenue for an insurance fund that could be used to bail out troubled financial companies when the next crisis inevitably hits.

As with carving banks down to size, Europe is taking the lead in exploring the financial transactions tax. U.K. Prime Minister Gordon Brown recently endorsed the notion, seconding Adair Turner, Britain’s top financial regulator.

The IMF is also studying it. Managing director Dominique Strauss-Kahn said last month the fund plans to raise the idea at a meeting early next year, noting that “the point here is to recognize that the financial sector is a more risky sector than the rest of the economy.”

Treasury Secretary Tim Geithner has pointedly dismissed the need for a transaction tax. And there’s little indication that most U.S. lawmakers would back it — at least for now. But support is growing among economists and policy analysts.

In a column last week, Paul Krugman said a financial transaction tax “would have helped prevent the current crisis — and could help us avoid a future replay.” Although no panacea, it “could be part of the process of shrinking our bloated financial sector,” he added.

Michael Ettlinger, vice president for economic policy at Washington, D.C., think tank Center for American Progress, favors giving Wall Street “a choice.”

They either get a financial transaction tax or offer an alternative way for us to tax them. After all, they can surely afford to be taxed. This is an industry that, if defined narrowly, handles upward of $50 trillion worth of transactions in a year. . . .  If the financial transactions tax creates the bad incentives [Wall Street has] described, then fine — come up with something different. You’re the experts.

Financial transaction taxes are often linked to Nobel Laureate economist James Tobin. In the 1970s, he proposed taxing currency speculation as a way of tamping down the wild exchange rate swings then roiling the global economy. With deregulation on the rise, the idea died.

But such proposals go back further than that — and not merely in theory. John Maynard Keynes famously advocated a transaction tax during the Great Depression. Meanwhile, stock transfer taxes in the U.S. date to the early 1800s. Between 1914 and the mid-1960s, the government applied a tax of 2 cents for every $100 on all stock sales or transfers.

There are several main objections to a financial transactions tax. One is that investors will find ways to dodge it. Charge for slinging derivatives in New York and London, and they’ll just zip off to Singapore or some other financial port of call, the argument goes.

Raising the cost of trading equities, meanwhile, would simply encourage speculation in other securities. And taxing certain kinds of trading would drive some players from the market, reducing liquidity. That would make it harder to exit bad investments, especially when panic is in the air.

Of these obstacles, the first is the biggest. Imposing a transactions tax would require significant international coordination to prevent investors from gaming the system. But that’s less daunting than it appears. As Krugman notes, trading these days is highly centralized. It’s not necessary to buttonhole traders everywhere — only where payment occurs. And most of that happens in London.

As for the other concerns, they strike me as lesser risks than what we currently face. After all, the financial crisis was caused in part by a surfeit — not shortage — of capital. In other words, the problem wasn’t that investors couldn’t bail out of certain positions — it was that they were in those positions in the first place. Perhaps they wouldn’t have been if the cost to make those trades had been higher.

Throwing a grain of sand in the gears of global finance, as Tobin described his tax, might also mitigate another major factor behind the crisis: speed. A defining feature of contemporary financial meltdowns is that they can happen overnight. For all the talk about the virtues of push-button, frictionless capital markets, we may have a collective interest in slowing them down.

For speculators, a transactions tax would be a small price to pay if their bets are right, while also raising the cost of being wrong.