The Quarter-Percent Solution?

The proposal to charge a ¼% tax on financial transactions doesn't sound like much, especially when we're talking about villainous Wall Street speculators making tens of millions of dollars per year. Surely, the speculators could "pitch in," as Nancy Pelosi has put it, and contribute such a modest amount to the national welfare. Leftists such as Dean Baker actually make it sound like they are doing financial markets a favor by proposing a transactions tax. Such a tax would, they say, calm the markets, head off future bubbles, and thwart speculation, all for the painless cost of a quarter percent.

In reality, this little quarter-percent tax would devastate America's financial markets and the broader economy. First of all, the "in and out" cost of a transaction is not a quarter-percent: it is a half-percent. Again, this might not seem like much, but consider how difficult is to make even 4% on a safe investment. When one factors in an average inflation rate of 3%, the resulting profit is only 1%, and this is before the effect of state and local taxes.

The sponsors of HR4191 are either so naïve as to have no conception of the operations of modern-day financial markets -- and of the competitiveness which makes a single basis point a crucial cost advantage -- or, more likely, so callous as not to care. They see an opportunity to curry favor with a poorly informed electorate by trashing Wall Street while at the same time placing within their grasp trillions of dollars of future tax revenues to secure future political advantage.

Unfortunately, those that might be harmed include the patient, long-term investors who invest their funds in IRAs, 401Ks, and other retail investments. These investments are generally low-yielding mutual funds for which trading costs make a crucial difference in long-term return. Barron's has calculated that the annual cost of a total market index, now 0.07%, would rise to 0.15% under the proposed tax. The loss of 0.08% per year, or a compounded 0.116% per decade, might not seem like much, but when it is imposed every year and compounded over the fifty-year investing lifetime of an average investor, it amounts to a great deal.

And this is the effect even in the case of the lowest-cost index funds. The annual turnover of the total market index in 2007 was 4%, thus the "passive" fund would accrue a tax of 0.50% (in and out) on 4% of assets. Turnover in the total bond index, in which the average bond maturity is typically 7%, would amount to just over 14%, so it would entail a tax on 14% of assets annually. Taxation of an actively managed fund, however, would be vastly higher. For most actively managed stock funds, turnover rates vary from 40% to 100% and more, and for short-term bond funds, as much as 50%. An in-out transaction fee would raise the expense ratio of these accounts by 0.50 to 2% per year. For bond funds returning 2% or less after inflation and taxes, the effect even of 0.50% would be devastating, reducing the return by 25% even before the effect of federal, state, and local taxes.

Nancy Pelosi, now shepherding HR4191 through the House, has made no secret about how she intends to spend the $150 billion in revenue it might raise annually. As reported by, Pelosi proposes to use revenue from the tax to fund future stimulus spending. But since the tax envisioned is a permanent tax, one imagines that within the minuscule gray matter of Rep. Pelosi, there has arisen the enticing image of a succession of annual "stimulus" spending packages with the fat-cat financial sector perennially milked to fund an ever-expanding welfare state. The enormous sums that the Speaker hopes to confiscate from the private sector could be put to "work" funding government make-work jobs, subsidizing health care for those who choose not to work, and funding increased regulation by the EPA and other agencies intent on strangling American enterprise.

Pelosi is not by any means the only one eyeing the transactions tax. Barney Frank views the tax favorably as well, though he is at least realistic enough to comprehend that its effect would be to drive the financial industry overseas. Thus, he proposes only a one-time tax -- a one-time tax that might, of course, be repeated each time the markets drop their guard. Larry Summers and Paul Volcker are also said to be interested in the idea.

The only problem with this jolly fantasy is that the thriving Wall Street industry that the parasitical Left are so intent upon draining would not thrive under the transactions tax. It would, as Rep. Frank recognizes, not even remain within our national borders. For her part, Speaker Pelosi is apparently yet unaware of the invention of the internet. In today's markets, financial transactions can be processed anywhere in the world, and in fact, most transactions at present are fulfilled electronically on computers that can operate just as well in Toronto, Bermuda, or the Bahamas as in New York or Chicago.

Make no mistake about it: the New York Stock Exchange and the Chicago Futures Exchange (and if PM Brown gets his way, the London Stock Exchange) would swiftly move outside of the United States (and Britain) to avoid this onerous tax. Traders would go about their business, just somewhere else. Markets are already consolidating and moving outside the United States as companies list elsewhere to avoid overregulation. There can be no doubt as to what would be the effect of a 0.25% transactions tax.

This is not an empty threat. Financial markets are intensely competitive. A half-point in and out, which seems so little to the leftist politician, would invalidate most present-day financial transactions. It would immediately put an end to day trading and trend trading, to say nothing of the high-speed trading of large investment houses. But contrary to the fantasies of liberal theorists, such short-term trading does not destabilize the markets. By constantly pricing and repricing a security, it lessens the likelihood of bubbles.

A transactions tax would also harm long-term investors who decide to rotate out of one investment and into another. This kind of trading is not the wicked speculation imagined by Nancy Pelosi and Gordon Brown; it is the prudent reallocation of capital to sectors or individual securities that are deemed safer or potentially more rewarding. Supporters of HR4191 would punish ordinary investors who merely wish to protect their savings or grow their retirement accounts.

Soon enough, investors would catch on. Who would be so foolish as to risk one's capital year after year in exchange for a guaranteed negative after-tax after inflation return? Capital would migrate elsewhere -- either to other asset classes or other countries (or it would simply be spent). The result would be the destruction of our financial markets and of our broader economy, which is dependent on the capital needed to grow businesses and hire new workers. Without investment, it would be impossible for businesses to expand or even survive. The effect of this scenario on our national economy would be equivalent to a nuclear conflagration. If the Democrats in power really wish to devastate our financial markets, put an end to growth in the broader economy, and drive jobs overseas, the financial transactions tax is the way to do it.

Dr. Jeffrey Folks taught for thirty years in universities in Europe, America, and Japan. He is the author of numerous books and articles.