Friday, November 20, 2009

Reducing Financial Complexity: A Different Take on Transaction Taxes

I’m working on a project that involves, among other things, looking at taxes on financial transactions, and I’ve thought myself into an idea that I’d like to float to our skeptical readership. The short version: Tobin taxes, Keynes taxes, and other financial transaction taxes have been sold on the grounds they would reduce price volatility. There is some controversy about this, and the case is not at all clear. I think, however, that increasing transaction costs could have the effect of reducing the complexity of trading strategies, and that might be a very positive thing.

The original proponent of a transaction tax was Keynes, who wanted to apply it to the stock market. He thought that it would have the effect of penalizing speculative strategies with high turnover, while rewarding buy-to-hold strategies. His views on financial markets as casinos are well known, and the tax proposal fits like a glove. Tobin, writing after the collapse of Bretton Woods and its fixed exchange rates, zeroed in on foreign exchange transactions. He worried about excess volatility in currency markets and applied Keynes’ logic to that sphere.

The argument about “real” versus “speculative” motives for transactions is plausible but much too simple. In particular, it makes assumptions about hedging strategies that are unfounded. The simplest version of such a strategy is that you take a position in the forex markets that is the reverse of the one you take in your real (goods and services) transactions. This means that you would double the volume of real trade to get the real-plus-hedged component of forex transactions, and as we know the latter is a vast multiple of the former.

But hedges can be quite a bit more complicated. One can try to hedge a variety of risk factors, not only exchange rates but also interest rates, commodity prices, etc., and these risks may interact in nonobvious ways. Moreover, one can shade or fine-tune a hedge, or generate a package of hedges that have properties that a simple reverse-position transaction cannot emulate. Without knowing the deep microstructure of these markets, it is impossible to know a priori how much of the transaction volume is risk averting (hedging) rather than risk-seeking (speculation).

Empirically, there have been studies that claim that transaction costs (which a transaction tax would augment) have been positively associated with volatility in foreign exchange markets. These, to my knowledge, have not been refuted.

As I see it, the intellectual and political winds have therefore shifted on transaction taxes. Keynes and Tobin wanted a tax big enough to change behavior, because they thought markets needed to be checked. Contemporary proposals, which are gaining momentum, have much lower tax rates precisely to avoid altering the behavior of market players. We are now hearing about a tax of a basis point or less on the value of transactions, not enough to change the way markets work, positively or negatively.

But I think the fixation on the terms of contracts (short term vs long) misses the point. A transaction tax penalizes a trading strategy according to the volume of transactions it entails. Consider again the hedge. A reverse position is the simplest hedge, and it consists of just one transaction. Granted, it may be too simple to meet the needs of sophisticated players, but this is not an argument for unlimited complexity.

Complexity renders market positions opaque and creates potential for systemic faults that are invisible even to the well-trained eye. Note that transaction costs fall as one moves from simple/actual transactions (like spots and outright forwards) to more complex ones (derivatives). Apparently such costs were not sufficient to prevent the emergence of fantastically complex strategies that entailed taking conditional positions in a plethora of markets simultaneously—a complexification that culminated in collapse. The conclusion appears to be that these costs need to be raised.

In other words, it is not the term of the trade that should attract a tax, but the sheer number of such trades to support a single position-taking.

I have argued previously that there was a dialectical relationship between the complexity of trading strategies and the extent of leverage. More leverage justified putting resources into increasingly complex strategies that offered minuscule margins. The perception that such mini-margins could be attained as a sure thing (all risk offloaded) justified leveraging that would otherwise have been viewed as outré.

Hence there may well be a case for a large enough transaction tax to alter behavior, but with a different purpose. The issue is not how much volatility it discourages, but how much complexity and inducement to excess leverage..


Shag from Brookline said...

Do you have a definition for "transaction"? I have some familiarity with the Internal Revenue Code and taxable and non-taxable transactions addessed therein, as well as some familiarity with tax policies involved in particular for non-taxable transactions. Are you suggesting that all "transactions" be taxable?

TheTrucker said...

In my opinion a tax on swapping paper is a fine idea simply because it won't change anything of real economic importance at all. Like a tax on land values it will not distort the real economy and it provides a source for the public funds.


Shag from Brookline said...

Is what is proposed sort of a sales tax on financial transactions? How might it apply to consumer banking? What kind of rates might be appropriate? Would such a transaction tax be on top of income tax on a transaction?

Anonymous said...

bakho says:
Taxing transactions is problematic. That is why we tax profits. Unfortunately, we do not tax capital gains profits the same as wages.

We need a "bailout" tax to recover our tax dollars spent on our financial sector from profits they record and from money and stock options they pay to CEOs.

TheTrucker said...

Anonymous said:

"Taxing transactions is problematic. That is why we tax profits. Unfortunately, we do not tax capital gains profits the same as wages."

The problem with our tax system is that it is not progressive and improperly designed to encourage true capital development. In 1936 the marginal rate on entrepreneurial income of what is now $250K was 15% while the rate on 3 million was 64%. In 1941 the marginal rates were made more progressive and the 3 million was taxed at 71% while the $250K was taxed at 39%. The tax rate on normal working people who earned what would now be $50k was 13%. Meanwhile, the capital gains tax rate was simply half the ordinary rate. So the tax on "capital gains" of 3 million was 36%.

So if you want to fix the tax code just reinstate the code from 1941 that understood "economic rent", and that taxation of economic rent DOES NOT adversely affect true production. Homes are not capital because they are not used in production. They are durable goods. And LAND according to any real economist is LAND. As such these do not qualify for "capital" gains treatment. Capital is trains and trucks and producing enterprises. And since money is also not capital then banks and insurance company stocks do not qualify for capital gains tax treatment either. If you want a capital gains tax break then build a productive enterprise. Even "UPS", and "Safeway" would qualify. "AIG" need not apply.

Kaleberg said...

You can think of the tax on a transaction as a user fee. After all, who is expected to enforce the terms of the contract, provide a court system, and provide the underlying title and currency?

Shag from Brookline said...

Does Krugman's column today (11/27/09) pick up on this topic?

Shag from Brookline said...

Mankiew questions Krugman on transaction taxes.