The Deficit-Reducing Potential of a Financial 
Speculation Tax

While a number of commissions and organizations around
Washington have produced plans for reducing the
projected deficit in the decades ahead, most have not
included a financial speculation tax (FST) in the mix.
This seems peculiar since an FST has several features
that could make it attractive as a revenue source.

By Dean Baker
CEPR
January 2011
http://www.cepr.net/documents/publications/fst-2011-01.pdf

First, it would help reduce the economic rents earned by
the financial sector. A tax on the turnover of stocks,
options, credit default swaps and other financial
instruments would make it less profitable to trade these
assets. To a large extent current trading patterns
reflect rent-seeking behavior with little or no economic
benefit.

For example, the complex computer algorithms that can
allow sophisticated traders to purchase assets ahead of
ordinary investors - and therefore gain at their expense
- provide no obvious benefit to the economy.

In fact, the use of algorithms to jump ahead of ordinary
investors reduces the expected gains from long- term
investment. If an FST can reduce this sort of trading,
it will impose no loss on the economy. This is one of
the reasons that even the IMF, an institution generally
friendly to banks, has advocated increased taxation of
the financial sector.

In addition, this sort of short-term trading can be
enormously profitable. The large banks and hedge funds
that engage in this trading are the source of many of
the country's highest salaries. In an economy where
inequality has soared over the last three decades, a tax
that will reduce the high- end salaries in the financial
sector can be an important factor in reducing
inequality.

It is also important to recognize that the tax will be
borne almost entirely by the financial sector, not by
ordinary investors. The financial sector is likely to
bear almost the entire burden of the tax since investors
are likely to respond to an increase in trading costs by
reducing the number of trades they make. Most research
suggests that trading volume is relatively elastic,
meaning that investors will sharply reduce the frequency
of their trades if the cost of a trade goes up.

For example, if the cost of an average trade of a share
of stock were to double as a result of a tax, the
evidence suggests that it would lead to a 50 percent
reduction in trading volume. In this case, investors
would be paying no more for their trades in total after
the tax than they did before the tax. 

They would pay twice as much on each trade as a result
of the tax, but since they make half as many trades,
they would end up paying the same amount in total for
their trades. This would mean that, on average, the tax
would not increase the amount that investors pay for
their trades. (It is worth noting that bills introduced
in the last session of Congress exempted from the tax
the vast majority of trades carried through by ordinary
investors.)

The United Kingdom has long had a tax of 0.25 percent on
each side of a stock trade. This tax raised an amount
that was just under 0.3 percent of the U.K. GDP in 2007,
before world stock markets plunged. An equivalent amount
of revenue in the United States would be more than $40
billion a year.

The U.K. experience is important for two reasons. First,
it shows that a tax on financial transactions is
collectable. The government has been able to collect a
substantial amount of revenue through this tax with
relatively little difficulty. In fact, the Board of
Inland Revenue (now HM Revenue and Customs) reported
that the administrative cost of collecting this tax is
lower than for any other tax. While some amount of
financial transactions has undoubtedly been shifted away
from the U.K. to avoid the tax, there clearly is still a
substantial amount of trading that is subject to the
tax, as the London Stock Exchange remains the largest in
Europe..

This raises the second reason why the U.K. experience is
important. The existence of the tax has not prevented
the U.K. from having a vibrant financial market. The
London Stock Exchange is the fourth largest stock
exchange in the world. Apparently investors view the
benefits of trading on the London exchange as being
valuable enough to outweigh the cost of the tax.
Presumably this would be even more true in the case of
the United States since the U.S. market is even larger.
Furthermore, the U.S. government is better positioned
than the U.K. government to use economic and political
power to discourage countries from establishing havens
for avoidance of this tax.

The revenue from the U.K. tax is based exclusively on
the taxation of stock trades. Ideally a financial
speculation tax would tax not only stock trades but also
trades of options, futures, credit default swaps and
other derivatives. A recent analysis that applied a
scaled set of taxes to a range of assets showed that an
FST could easily raise more than 1.0 percent of GDP
(approximately $150 billion in 2011) even assuming very
substantial reductions in trading volume.5 Given the
size of the potential revenue from an FST, there is
remarkably little interest in Washington policy circles
in implementing such a policy.

By comparison, the amount of revenue that could be
raised from an FST is more than two and a half times the
amount of money needed to pay for the extension of
Unemployment Insurance benefits in the recent tax
agreement signed into law at the end of 2010, as shown
in Figure 1.6 It is more than one-third larger than the
size of the 1-year payroll tax reduction that will be in
effect in 2011. CEPR The Deficit- Reducing Potential of
a Financial Speculation Tax ?? 3

The potential revenue from an FST is also large relative
to other budget items. At one percent of annual GDP, it
would raise more than $1.8 trillion over the course of
the next decade. This is more than twice the size of the
estimated cost of the stimulus package that Congress
approved in 2009, as shown in Figure 2.

The projected shortfall in the Social Security trust
fund provides another useful comparison with the
potential revenue from an FST. The Congressional Budget
Office projects that the shortfall over the program's
75-year planning horizon will be equal to 0.6 percent of
GDP over this period.7 This means that at 1.0 percent of
GDP, the potential revenue from an FST is more than 50
percent larger than the projected size of the Social
Security shortfall as shown in Figure 3. In other words,
the Social Security shortfall could be entirely filled
with the revenue from a tax on financial speculation,
with a substantial sum still available for other
purposes.

Another item that provides a useful comparison to the
revenue that could be raised from an FST is the
projected gap in state budgets. The Center on Budget and
Policy Priorities projects that the cumulative shortfall
in state budgets in fiscal 2011 will be $160 billion,
with a gap of $101 billion remaining after taking
account of funds coming from federal stimulus programs.8
If an FST raised $150 billion in 2011 then it could
provide the federal government with almost enough
revenue to fill the full gap and $50 billion more than
the amount of revenue needed to fill the remaining gap
in state budgets, as shown in Figure 4.

Conclusion In a context where deficit reduction is now
playing a central role in Washington policy debates, it
is striking that financial speculation taxes have
received almost no attention. Calculations that assume
sharp reductions in trading volume from current levels
show that an FST can raise an amount of revenue that
exceeds 1.0 percent of GDP. This is not just a
hypothetical; the revenue collected by the U.K. on its
more narrow tax on stock trades shows that it is
possible to collect large amounts of money through such
taxes. Furthermore, the incidence would be almost
entirely on the financial industry and those involved in
very active trading.

The potential revenue from such a tax far exceeds the
amount of money involved in most items that are heavily
debated in Congress, such as the extension of
unemployment benefits or the tax breaks going to the
wealthiest two percent of the population. The revenue
from an FST also vastly exceeds the size of the
projected Social Security shortfall. Given the amount of
money potentially at stake and the progressivity of the
tax, it is surprising that it does not feature more
prominently in policy debates. It is not clear what
possible downsides would be posed by such a tax, except
for its negative impact on the income of people
connected with the financial industry.

___________________________________________

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