Why Taxing Trades Won't Improve Markets

Finally, a non-credit-crunch-related post.

Jesse Eisinger has an intriguing column in the latest issue of Portfolio arguing for a small tax on the trading of stocks, bonds, and other instruments.

(BTW, Jesse wrote a very prescient piece in October anticipating the end of independent investment banks -- a highly recommended read.)

The reason we need a transaction tax, Jesse says, is that it would help prevent investor myopia and all the nasty things that come with it:

Though volume increases every year, intelligence doesn't. Short-termism and noise distort company decisionmaking, and managements are forced to try and please investors who want to jump in and out of stocks with little friction.

What's worse, short-termism may even lead to asset bubbles:

Acolytes of market fundamentalism argue that active markets help prices do a better job of reflecting the true value of assets. Yet during a stretch when trading was at a peak, we experienced two of the greatest bubbles in the history of the world--the late-1990s tech bubble and this decade's housing and credit bubble.

A transaction tax would also help slowdown the growth of two types of investors:

The first is made up of traders who erroneously think they can beat the market but in fact are just responding to noise. They read charts and measure momentum; they don't care about fundamentals. The second group is made up of those who gather the "little crumbs," in the words of Sherman McCoy's wife in The Bonfire of the Vanities. These are the brilliant quantitative hedge funds that have computer programs executing countless trades every second. The world would benefit from the shrinking of these two groups.

And some economic heavy-weights have supported the idea of such a tax, from James Tobin to Joe Stiglitz:

"As an economist, I begin with a general suspicion against narrowly based taxes," [Stiglitz] began. But he overcame that reservation, arguing that such a tax would make the stock market more efficient and reduce price volatility. It's a tax that's meant to correct behavior, as described by the English economist Arthur Pigou.

But I have some problems with all of this, the biggest being that there's little evidence to back it up.

Some academics do voice support for transaction-taxes, yet most of the evidence they offer is theoretical. But a number of empirical studies have shown that, if anything, higher transaction costs increase volatility. For example, research by INSEAD's Harald Hau found that volatility decreased after the French stock market got rid of its tick size rule. (A 1998 study of the American Stock Exchange had similar results.)

Other research has found little correlation between transaction costs and volatility. This paper, by Taiwanese economist Robin Chou and George Mason University's George Wang, looked at what happened following a tax reduction on futures market trades on the Taiwan Futures Exchange:

Our analysis is not consistent with the argument that the imposition of a transaction tax may reduce price volatility, since there are no significant changes in price volatility after the tax reduction.

While I'm agnostic about the prevalence of technical analysis -- one of the groups that could see their growth hurt by a transaction-tax -- it's hard to see how rapid-trading hedge funds are harming markets. Sure, many funds found out that they were using the same strategies in the summer of 2007 -- and suffered accordingly. But since then, word of the destructive capacity of renegade funds has died down considerably.

You can even make an argument that these funds have had a net positive impact on markets. And Exhibit A here is that, starting in the mid-1990's, many of the market pricing puzzles that didn't match up with the efficient market hypothesis started to disappear. The reason? Better technology allowed hedge funds (and others) to exploit small price discrepancies for profit -- until too many of them started to do it of course.

Finally, as for higher trading volumes leading to asset bubbles, let's take a look at a recent bubble. This chart shows the Nasdaq from 1994 to 2005.

Volume did grow as the index reached bubble territory in the late 1990's, but volume after the crash is either higher than or equal to the levels before the tech-boom imploded. (The counterargument here could be that bubbles and trading volume only have a positive relationship on the way up, but why would that be the case?)

All of this isn't to say that trades shouldn't be taxed. If, for example, redistributing wealth is a public policy priority, then go ahead. But it's far from clear that taxing trades would have the desired outcome of reducing investors' short-sightedness.

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