Advocating Tax On Stock Trading

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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.

Which brings us to what may be a very controversial solution to all this, an old idea that can be new again: a tax on short-termism. We should have a small transaction tax on all financial trades. The more you trade, the more you pay.

Short-term trading has a social cost. Getting a piece of information a few minutes early and trading on it doesn’t create any value; it simply redistributes value. It may even damage the economy. Nobel Prize-winning economist Joseph Stiglitz illustrated this in the late 1980s with this example: Say $100 bills are put at the feet of a group of naturally lethargic people, who pick up the money at their leisure. Then an energetic person comes along and decides to run around the lazy folk and pick up the $100 bills. This forces people to sprint for their money, using more energy to achieve the same result. “They are unambiguously worse off,” Stiglitz wrote.

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. If anyone still believes that financial markets are getting prices right, I’ve got a C.D.O.-squared made up of mezzanine tranches backed by subprime-mortgage debt that I’d like to sell you.

Thanks to the credit crisis, there is a wide consensus that the U.S. needs more and different financial regulation to deal with built-up excesses. The Federal Reserve is lending to investment banks and will likely bring them under its regulatory umbrella. The S.E.C., hopelessly emasculated during the Bush-Cox regime and recently mired in its pursuit of rumormongers, will need revamping.

Regulatory reform is necessary, but regulation has its limits. It’s arbitrary. So along with new and better regulation, we should introduce a tax on trading. In the 1970s, James Tobin, another economist who would go on to win the Nobel Prize, championed a levy on speculative currency trading, which became known as a Tobin tax.

But we should tax all transactions, based on the value of the asset being traded. Dean Baker, an economist for the left-leaning Center for Economic Policy Research, argues that a small tax (say 0.25 percent, though it would vary depending on the asset) be levied whenever a financial instrument—a share, mortgage securities, a credit derivative—passes from one owner to the next. Trades wouldn’t be legal unless the tax had been paid.

This isn’t so unthinkable. After all, we already pass judgment on whether we should encourage long-term holding through the tax structure. We have capital gains taxes that fall more heavily on short-term gains than long-term ones.

At the margin, such a tax would hinder short-term speculation. For long-term holders, the impact would be small, diminishing in significance over time. Those investing on fundamentals would be almost untouched. But the tax would slow down the two groups that are doing little to help the markets. 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.

One category of passive, ignorant investors wouldn’t be harmed, and that’s okay. These are the index investors in 401(k)s and retirement accounts. Yes, they contribute to distortions. They ignore fundamentals and are price-agnostic. But they are long-term holders. It’s only the index speculators slinging around exchange-traded funds who would feel the weight.

Transaction taxes, which exist in many markets abroad, have attracted surprising fans. In the late 1980s, prominent young economists embraced the idea. It’s no coincidence that this occurred in the aftermath of the horrific stock market crash of 1987. Lawrence Summers, who would become Bill Clinton’s Treasury secretary, co-authored a sheepishly titled paper, “When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax.” These days, of course, our problem is not that capital markets work too well, making the case for a transaction tax even stronger.

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