The Stash

Why Taxing Trades Could Make Sense

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The UK's top financial regulator, Adair Turner, has suggested a tax on all financial transactions around the world. The purpose of this tax, he argues, would be to prevent the return of "business as usual" for the banking sector: "If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit."

Transaction taxes -- better known as Tobin taxes after Yale economist James Tobin -- have been proposed and implemented in the past to discourage speculative short-term trades and reduce market volatility. (They also do a nice job raising money for governments.) But the findings of a number of studiessuggest that Tobin taxes may actually increase volatility--a possibility that Tobin, it turns out, was aware of (emphasis mine): 

The hope that transactions taxes would diminish excess volatility depends on the likelihood that Keynes's speculators have shorter horizons and holding periods than market participants oriented to long-range fundamentals. If so, it is speculators who are the more deterred by the tax. But it is true that some stabilizing transactions might also be discouraged; fundamentalists alert to long-run opportunities created by speculative vagaries would have to pay the tax too.

For Tobin -- who proposed the idea as a tax on foreign exchange transactions -- the levy was primarily meant to give emerging market economies the ability to exercise some power over their national monetary policies and to act as "a measure of opposition to the dictate of the financial markets."  

It's in the latter sense in which a transaction tax could make sense today. It's impossible to say whether transaction taxes by themselves would have prevented the subprime crisis, but there's one reason to think they would have had some good effects: Increasing the costs of behavior we don't find beneficial (in this case speculation) tends to discourage that behavior, something taxes have accomplished in other walks of life. It's certainly not the best comparison, but gas and mileage taxes have been shown to reduce car crashes and fatalities.  

As Justin Fox points out, Turner's Tobin tax proposal might have been more of a PR move than a serious proposal, but let's hope it gets more attention.

 

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