A financial transactions tax would bite investors

Wealthy investors know that tax increases are in their future. The Obama administration and the Democratic Congress have made it clear they will allow the Bush administration tax

cuts for the top earners to expire next year, pushing the top income tax rates up to the 39% of the Clinton era.

The health care reform bills making their way through both houses of Congress would impose additional tax increases on upper-income earners, raising the top rate to well over 40%.

But these increases will not be enough to reduce significantly the enormous federal deficits that are projected for the next few years, and so the search is on for other sources of revenue.

One tax proposal that could be a dark horse in the race to raise revenue could greatly affect all in-vestors, not just the wealthy.

The candidate receiving the most mention is a European-style value-added tax, which is a tax applied to the value added at every stage in the production, distribution and sale of goods, unlike a conventional sales tax, which is applied on the final sale.

For politicians, the value-added tax has several features in its favor. First, it can raise enormous amounts of money. France’s VAT brings in 52% of the national government’s revenue. Second, it is harder than income or conventional sales taxes to evade, since each producer has an incentive to ensure that its suppliers pay their share.

But many in Congress don’t like the VAT, because it appears regressive. People of limited means pay a higher percentage of their income when they buy things than the wealthy do. It is difficult to apply different VAT rates to people at different income levels. Different goods and services — e.g., food — can be taxed at different rates, but this complicates an otherwise simple tax.

House Speaker Nancy Pelosi, D-Calif., has endorsed the idea of a value-added tax, but as yet, no proposal for such a tax has come out of the Ways and Means Committee.

The proposed tax investors must be wary of is one that would be imposed on all financial transactions. Rep. Peter DeFazio, D-Ore., has introduced a bill that would levy a tax of 25 basis points on such transactions to repay the federal government for the bailouts. It has been referred to Ways and Means.

While the committee has not yet taken action on the bill, investors and advisers should be on guard because the bill could be a more attractive way for Congress to raise additional revenue in this environment, because it appears to punish the very people many believe caused the financial crisis.

Those proposing it also believe that it would reduce speculation and short-term trading in the financial markets, especially the derivatives markets.

In fact, the tax no doubt would be passed on to individual investors through higher fees or lower returns on investment.

While it would reduce transaction volume, and possibly speculation, it would also make the U.S. financial markets less competitive in comparison with those in countries that did not impose such a tax. Many transactions would simply move overseas.

Planners and investment advisers should be ready to fight such a transaction tax, and prepare their clients to oppose it also.