Link to Mehul Gaur’s LinkedIn Homepage

I am delighted to host another student guest post by Mehul Gaur. This is the 6th student guest post of this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

Bernie Sanders’ proposed 0.5% tax on stock transactions is not only going to dry up liquidity in the markets, but may actually serve to lower tax revenue overall.

Bernie Sanders has been making quite a name for himself recently. After announcing his candidacy for presidency, Bernie has positioned himself to the left of the standard Democratic Party stance and proposed an estimated $15 trillion healthcare reform. One of the ways he has proposed to pay for this massive expenditure is to levy a 0.5% tax on each trade of stocks, bonds, and derivatives. Opponents of the tax argue that it would make it impossible for high-frequency trading firms to operate, put off speculators, and reduce volatility by making very low-margin computerized trades unprofitable.

If Bernie is using this as a piece of political propaganda, its genius. To someone not familiar with the financial markets (the majority of voters), it seems like a tax that provides wide social benefits at a very low cost to “those rich traders” on Wall Street. However, if Bernie is serious about implementing this, he could be doing something that would derail the financial markets and possibly cause another stock market crash.

Let’s start with what supporters of the policy are right about: It will drive high-frequency traders (HFTs) out of business. Their profit margins per trade are well below 0.5% and it will essentially eliminate the industry.

There’s just 1 tiny problem with that: It is estimated that HFTs make up somewhere between 50%-75% of all trading volume in the United States. So, by implementing this tax, one would essentially be directly eliminating at least half of the liquidity in the equity markets. But we got rid of the evil HFTs right? HFTs are widely believed to actually help the markets by both adding liquidity and reducing trading costs. Additionally, by cutting the trading volume in half one would also be reducing the potential revenue from the tax. It may also have a net negative effect on tax revenue because of reductions in capital gains taxes. Bernie did not provide any numbers on this, but as I discuss later, both of these statements have an empirical basis.

Next, the tax would affect all sorts of institutional investors (investment banks, mutual funds, hedge funds, etc.). Currently, these funds average transaction fees of 7 basis points. Adding a tax of 50 basis points would radically affect their returns and cause them to cease activity. Additionally, most 401(k)s are invested in these types of funds, so the tax would essentially be reducing the value of investors retirement accounts. Another important point to note is that by taxing bond transactions, the government is inhibiting the ability to raise capital for not only corporations, but itself.

Obviously, this is all conjecture, but it is not entirely baseless. Sweden, in 1984, introduced a 50 basis point tax on all equity transactions. In 1986, the tax was doubled to 100 basis points. After this second announcement, 60% of the traded volume of the 11 most actively traded Swedish share classes, accounting for 50% of all Swedish equity trading volume, relocated to London. By 1990, more than half of all Swedish securities trading had moved offshore. The government reacted to this by introducing a tax on fixed income securities. Within a week of the introduction of the tax, the volume of bond trading fell by over 85%, futures trading fell by 98% and the options market ceased to exist. Also, the incremental revenue generated by the equity tax was almost entirely offset by the loss in capital gains tax. (More information about this tax can be found here)

This post was inspired by my reaction to How to Avoid Another Market Crash, by Douglas Cliggott (Lecturer of Economics at University of Massachusetts Amherst). Contrary to his favorable view, I think introducing Bernie Sanders’s tax on the capital markets is a bad idea. It is one that will overall generate much greater costs than benefits. It will severely inhibit firms ability to raise capital and by reducing liquidity, may actually serve to magnify volatility in the markets. It is by no means, as Douglas Cliggott would have you think, a perfect tax.