A financial transaction tax is a Pigouvian tax!

April 22nd, 2015 at 10:22 am

This morning’s NYT tells of prosecutors finally catching up with the alleged perp behind the “flash crash” in 2010, when the Dow fell almost 600 points in a few minutes. It bounced back soon after, but not until everyone’s nerves were seriously jangled and confidence in the soundness of the equity markets took a big hit.

US prosecutors allege that the crash was the work of a guy in a London row house a few miles from Heathrow. That’s right, some schlub in his bathrobe supposedly tanked the markets by “spoofing:” algorithmic trading that executes tens of thousands of buy and sell orders only to cancel them milliseconds later. Once the market reacts to the spoofer’s large bets for or against the stock, she moves in and cashes in on the price change. Basically, a high-frequency variation of “pump-and-dump.”

As the Times notes:

The case also played into worries that have swirled around the increasingly automated and complex financial markets, where regulators have struggled to keep up with nimble new participants like high­-frequency trading firms that use sophisticated networks to make money in milliseconds using rapid-fire trades.

Regulators have various ideas of how to regulate against spoofing, front-running (where flash traders get information on trades milliseconds before the public), and other such high-frequency fun and games; I’ve written about them before. They generally work by creating speed bumps in the trading process, say by moving from continuous trading to “batch trading,” thereby taking away the millisecond advantages of the flashers.

That might work, but it might not. You ask me, an arms race against quants who live to write regulation-beating algorithms is a recipe for more of the same. For example, suppose batch trades across different exchanges are not perfectly synchronized. That’s an opportunity for high-frequency arbitrage.

A better, simpler way—and one with numerous positive externalities—is a financial transaction tax, a small excise tax on the security trades, typically a few basis points (hundredths of a percent) on the value of the trade. A three basis points FTT is scored as raising over $300 billion over 10 years, a score that includes its dampening impact on trades.

Of course, that last bit is a feature, not a bug. We’d have to try it to find out, but it is widely believed that an FTT, even one of the tiny magnitude just noted, would wipe out most high-frequency trading. Though the flash boys can generate huge payouts, the volume of trades they must execute to do so quickly becomes too costly once they’re taxed.

In that regard, the FTT is a Pigouvian tax: a tax that offsets the significant, external costs imposed on the larger society by activities like smoking or polluting. And it does so while generating much needed revenue.

There are, of course, arguments against the FTT—by reducing trading, it dampens liquidity; it pushes traders to other exchanges to escape the tax. I deal with some of these concerns here, as does Dean Baker here. I take these concerns seriously, but my strongly held belief is that the likely benefits outweigh potential costs.

Perhaps the most valid concern in the Pigouvian context is that an FTT would fall on everyone, not just the flash mob. However, that’s not unique to the FTT. It takes me about two years to go through a bottle of whiskey, but I still have to pay the “sin” tax. It’s the heavy drinkers who bear the brunt of the tax, as would the high-speed traders in the case of the FTT.

So instead of a technical workaround that the quant jocks could probably beat before the regulators had their shoes on, the smart move here is to introduce a small FTT. I’d love to see this idea surface in the forthcoming campaign…any takers???

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22 comments in reply to "A financial transaction tax is a Pigouvian tax!"

  1. Smith says:

    Sen. Elizabeth Warren supports a financial transaction tax.
    If Clinton doesn’t I’ll vote for Sanders at least as protest vote.
    It’s a no brainer.

  2. James DePorre says:

    How about a tax on journalists that propose taxes??

  3. Pete Davidson says:

    A transaction tax should NOT hit IRA, Roth IRA, 401k, Roth 401k, 529 College Savings Plans, and health savings accounts.

    Dont give me the garbage it is a “small” tax.

    It is only “small” to people with a ton of money.

    Each of those accounts I listed are cash accounts, not margin, and therefore are not HFT accounts.

    You penalize Main Street people for no reason at all with this idea.

    Regulation can solve the HFT issue, without taxation.

    Taxation wouldnt stop it anyway.

    Only regulation will.

    • Smith says:

      The tax savings from investing in IRAs and 401Ks are minimally 15% to 25% assuming they are funded by ordinary income. How can you complain about a .5% tax when you are already saving 15% to 25%? Even heavily managed mutual funds have a turnover rate of 100% (index funds a mere 10%), meaning the average investor takes the hit of .5% off his investment at most just once a year.

      Quite the opposite of what you state, the FTT is only “large” to people with a ton of money. The financial wizards who have millions and billions to invest in order to take advantage of minute price differences would lose money because they must execute thousands of transactions each with very small margins in order to gain an adequate aggregate return equal to or greater than normal investing.

      Additionally, everyone already pays for the money extracted from the market and economy caused by HFT. That’s without even considering how their shenanigans contribute to the actual crashing of the market, which suffered two enormous bear markets in the 2000’s.
      I would favor regulatory control to limit or outlaw HFT because the tax would not prevent every type of abuse or advantage those with extraordinary money and skill used to gain advantage over the average investor, without adding value to the economy.

    • Richard says:

      Pete: your bid/ask spread is probably 100 times larger than the task. As is the churn if you are a day trader.

      A $30,000 purchase to re-balance a $500,000 portfolio with a fee of 1 basis point would be a $3 charge. If you use a discount broker that’s less than the $5, $8, $10 or $15 charge that some of the lowest cost brokers. If you’re not using Vanguard, you’re probably already paying more than any fee would cost.

      Taxation would stop the spiral of HFT down to ridiculous levels of speed and numbers of transactions.

  4. Mike Estanza says:

    What the guy did according to reports was SPOOFING. A Financial Transaction Tax would not stop SPOOFING. SPOOFERS do not execute a single share of stock. The Spoofer would have paid NOTHING in financial transaction taxes. You got to prosecute criminals. That is how you solve it not a new tax.

    • mitakeet says:

      However, if you tax the transaction order itself the spoofing would come to a crashing halt. Right now it costs a wee bit of electricity and some bytes on a network, barely measurable. However, if it cost a few pennies per order (whether it was filled or not) suddenly the economics of making 100K transactions a day changes dramatically.

      @Pete: If the transaction tax was on the order of pennies/event it would have no noticeable effect on the vast majority of retirement accounts which are traded thinly, if at all, over the course of a year. There will always be a few people pinched, I have a friend who (so far successfully) day trades with his retirement account, but even there he is making a dozen or so transactions a week and I expect pennies a trade wouldn’t have any measurable impact on his outcome.

    • o. nate says:

      This is why it would be better to have a tax on orders (filled or not), rather than on transactions.

  5. Duped says:

    I think it is a valid idea, but I fear that even this tax could not really solve the problem. Some of the high-speed trading techniques are so profitable that this tax would be just a very small cost of doing business in the world of high-speed trading. It might weed out the guys/gals in their bathrobes that do this as a hobby, but it wouldn’t necessarily dampen the large traders very much necessarily. And that alone could shift the advantage even further in favor of large traders.

    I don’t have a better answer right now, however. This has always been a problem even before the time of computers. High-speed trading via loud, fast, aggressive people on the floor caused many meltdowns also. The major problem with computerized high-speed trading is that it has the potential for instability beyond what in-person trading has. It just amplifies the problem.

    I suspect the only real answer to the problem is for regulators to keep ahead of the traders, and that means starting with some gatekeeping, reducing the allowed frequency of trading, and by having laws that would ban people from trading if they violate the rules.

    I don’t think jail time is appropriate necessarily, nor are fines. Rich people can pay fines as a CODB and this will always be a subjective judgement call, and it isn’t good to put people in jail based on subjective judgement. Banning them from trading, with progressive punishment after that seems more appropriate.

    These really are just some random thoughts on the subject.

    • Jon Marcus says:

      I don’t believe those techniques are very profitable *per trade*. They’re profitable when made en masse, if each trade nets you tiny percentage profit but you do 100k trades/day, you can rake in some big $. A FTT would destroy that tiny percentage.

      If an individual trade shows a decent profit, then it’s useful almost by definition. If I know that oil (or Euros, or AT&T debt, or whatever) has become more valuable and I buy it, I’m sending a useful signal to the market. If I know that there’s a glitch that makes Euros slightly less valuable for 5 milliseconds at 10:17:34.542 EST and I take advantage of that, I’m just gaming the system.

  6. leander says:

    Isn’t the problem with a FTT that it would have to be imposed internationally?
    Since there are practically no costs from switching countries.
    If a FTT would be imposed in US they would all just go to London or Singapur or Hongkong…..

    • Ike says:

      Could this not be overcome by making any transaction in the currency of a country liable for taxation paid to that country with inter country agreements put in place. If a country did not agree to deduct the tax then any transactions involving their currency could be suitably penalised to recover the loss.

  7. mitakeet says:

    Sarao is being scapegoated. This activity is done by all the HFT guys and there is no way trading at that scale (100-200 M) (btw, he did it for years before and has been doing it up until he got arrested) can cause that sort of movement on a market of trillions. If he was indeed the source of the problem then they should have had him arrested within days, if not sooner, yet here we are 5 years later. I think it took them that long to find their Oswald, someone whose activity could be sold to the credulous sheeple yet wouldn’t negatively impact the big HFT outfits.

    My prediction is that he will get bailed out and spend the next decade or so ‘fighting’ extradition (I am quite sure no one in the US actually wants him to stand trial), then some statutes of limitation will be trotted out to explain why he wasn’t actually prosecuted to the three or four people who still remember what this is all about.

  8. Matthew Kilburn says:

    More attempts to put the greedy mits of the welfare state on the hands of the incomes of successful Americans. If HFT is such a danger to the system – a claim which I won’t pass judgment on – then simply require completion of orders and mandate a hold period on equities of, say, 24 hours.

    We don’t need to give the Warren- and Sanders-types another excuse to feed the beast.

  9. David Viel says:

    A small transaction tax makes sense in this trading environment. If anything the markets are too liquid allowing for chaotic shifts that cause the kind of damage done by the flash crash. This excessive liquidity is like an under-damped spring that oscillates wildly. This is what happens to a car when its shocks wear out, where it bounces down the road. A properly functioning car suspension is said to be “critically damped” where it smoothly transitions back to a steady state after hitting a bump. Markets need liquidity, but only in the amounts enough for committed trades. Markets should enable value investments where those who seek to purchase a valuable investment can do so readily, but discourage rapid trading for the sake of trading. The latter is pure speculation that is unrelated to value creation. A value investor is unlikely to be discouraged by a small fee, where as the rapid trading speculator would see all his profits evaporate due to that fee.


  10. Ike says:

    A Financial Transaction Tax could replace other forms of Tax as it would be all encompassing. When your wages are paid,Income tax, when you buy something,GST/VAT, When you buy a house, Capital gains tax. The only way around it would be cash transactions which are already used to avoid tax and therefore no change and would give the tax authorities something to do as they would no longer be required as a FTT could be automated using bank computers. So simple, but it would impact the banks therefore unlikely to be implemented.

  11. Rudy says:

    I did the maths… 3 basis point, on 100% of the volume (250 bn/day), 250 trading days a year, for 10 years, is… 187bn. Already half what Jared Bernstein announces… and that’s if volumes don’t fall (which he is supposed to take into account, they suppose volumes will double ??). It is kind of worrying that somebody making tax policy recommendations could be either so blatantly lying or bad at maths… As explained below, with a 3 basis points tax, volumes would probably fall 70 to 90%, making the receipts very very far from 300 bn over 10 years…
    When you trade in the markets, you most likely trade with an intermediary (whether HFT, or a bank, hedge fund,…). The people provide liquidity at a small premium compared to the fair value (the half spread), they accept a risk and hope somebody will come and trade on the other side (so that they can close their position at a small profit). If this intermediary has to pay 3 basis point on the first trade, and 3 basis points on the exit trade, don’t you think that he (and all other people competing to provide liquidity) will ask for a bigger premium ? That will for sure be at least an extra 3 basis points (the tax) on both ways. So get a FTT of 3 basis point and all spreads are already wider by 6 basis points at least. But then it becomes more expensive to trade (every trade costs in spread crossing and its tax an extra 12 basis points: the 6 bis of tax plus the 6 extra basis points of spread), so trades are less frequent, so market makers make less trades a day, so holding a position is riskier (an extremely optimistic scenario would be volumes divided by 4 but 10 is more realistic with a 3 basis points tax), the market makers will further widen their quotes and you have a snowball effect when the spreads get out of control (dozens of basis points to trade in one direction), to the point where the general public would really feel it in their retirement accounts (5 or 10% less than without it), not even mentioning that the equity markets as a whole would fall as it would become a less liquid investment (there are dozens of papers in the literature about this, from economists of all horizons who are quite unanimous on this: dampen the liquidity of an investment and it will fall), hurting considerably those who already started saving. It should also be taken into account to other types of tax receipts will fall (capital gains tax, interest, dividends, profits of banks and intermediaries,…), as people will invest less in the markets due to the extra cost. It has been documented (notably by the european, see here http://www.forbes.com/sites/timworstall/2015/04/24/jared-bernstein-is-wrong-hft-is-not-a-problem-that-needs-curing-with-an-ftt/), that this alone would already offset any positive tax revenue from the tax. Please stop with these stupid recommendations…

  12. Rudy says:

    Regarding the “dampening” effect of the tax on volumes: the HFT industry makes less than a billion dollars trading equities per year, and are responsible for 50 to 70% of volumes according to most estimates, there is no way they are going to foot 50-70% of the tax bill (announced at 300 bn, that would be 20 times their profits…). Simple economics show that would effectively “kill” them, but then one has to be self coherent, and the dampening effect on volumes will be, at the very least, 50 to 70% (we know there is a Keynesian multiplier to these things, explained in the previous comment, final figure will be more in the 70-95% range). So any tax collection projection which does not include at least a 60% drop in volumes is pure fantasy.

    • Jared Bernstein says:

      If you’re saying a 3 bps FTT will reduce trading volumes by 60%, that’s not credible. JCT score, ftr, does include lowered volumes and they score a 3 bps FTT as raising about $350 bn over 10 years.

      • Rudy says:

        You cannot say that you will get rid of all HFT shops (who trade an average of 60% of the market…) and pretend somebody is going to do their volume for them… You can see a real world example of a transaction tax here (http://en.wikipedia.org/wiki/Financial_transaction_tax#Sweden) and you will see, 60% is a very optimistic value (my guess is really we would be more in the 80% range). You can maybe do 0.5 basis point and only impact volumes 10-15%, but 3 basis points is huge compared to what most financial actors (volume weighted) make in one trade

      • Rudy says:

        And by the way, the “JCT estimate” is just the Peter De Fazio (a long advocate of the tax) estimate, for a 0.25% rate, over all instruments (much wider in scope than 3 basis points on equity trades).
        To give you an idea of how bad governments are at predicting revenue windfalls from such a tax, the French thought they would raise 1.6 bn per year with theirs, they are actually making 500 mn/year, when they doubled the rate in the meantime, they are effectively off by a factor 6… Sweden tried it and acknowledged they lost tax revenues overall… This gets people excited (a tax, of “Finance”) but this is a bad one, the financial responsibility fee (which has some kind of bipartisan support) is a much better alternative, and contrary to the FTT, puts the burden on the people responsible for the last crisis.

  13. Lee Shelly says:

    The tax should be 200 basis points on synthetic derivatives.