Hark: Beware of Harkin tax plan

Investors, beware of the financial transactions tax proposed by Sen. Tom Harkin, D-Iowa, and Rep. Peter DeFazio, D-Ore. The tax may appear to have no chance of adoption at present, with the Republicans in control of the House and in position to block many proposals in the Senate, but the situation could change after the 2012 elections.

If Barack Obama retains the presidency and the Democrats regain control of both houses of Congress, we could see a tax on securities trades, especially if the passions evidenced by the Occupy Wall Street demonstrations remain high.

The proposal from Mr. Harkin and Mr. DeFazio calls for a tax of 3 cents on every $100 of the market value of trades in stocks, bonds and derivatives.

The proponents’ key arguments are that it would slow down or even eliminate high-frequency trading by wiping out the minuscule margins on which high-frequency traders operate and, more significantly, that it would raise additional revenue for the federal government. In fact, some estimates place the possible receipts from the tax at $350 billion.

They argue that the tax is so small that it would not significantly affect individual or long-term investors, and that eliminating or reducing high-frequency trading would make the markets less volatile and thus better for other investors.

In a breathtaking display of economic ignorance, Mr. Harkin declared: “This measure is not likely to impact the decision to engage in productive economic activity. There’s no question that Wall Street can easily bear this modest tax.”

Does Mr. Harkin not realize that customers, not Wall Street, would pay the tax? As opponents of the proposal argue, the proposed levy — effectively, a sales tax — would increase the cost of investing and be passed on to the ultimate customer, not absorbed by the brokerage firms, hedge funds and other professional traders at whom it is nominally aimed.

In effect, it also is a tax on liquidity. As anyone who has studied economics knows, when you tax something, you get less of it, so the result would be less liquid markets and more-costly transactions.

A MOVE OFFSHORE?

Finally, a transactions tax might drive trading and investing offshore to financial centers, such as Singapore or Dubai, that don’t impose such taxes. Academic research suggests that after the imposition of a transactions tax, market volatility would rise, while trading volume —and with it, liquidity — declined.

In Sweden, for example, where a financial transactions tax was introduced in 1984, not only did securities trading volumes fall, but revenue from capital gains taxes also fell. The yearly revenue from the transactions tax averaged only 3% of what had been forecast by tax proponents, and was entirely offset by the losses of capital gains tax revenue. The Swedish tax on equity transactions, however, was 0.5%, far higher than the one Mr. Harkin and Mr. DeFazio propose.

On the other hand, though the Swedish tax on bond transactions was lower than the rate in the Harkin-DeFazio proposal, bond trading plunged 80% in the week after the tax was introduced. The Swedish transactions tax package was repealed in 1991.

Other dangers regarding the transactions tax proposal are that the low initial tax rate, 0.03%, might be absorbed by investors without too much pain, leading it to be raised quickly to a more burdensome and damaging rate.

That is what happened with the income tax in the U.S., and, more recently, with the value-added tax throughout Europe.

Another danger is that a transactions tax could be extended quickly to other financial transactions, including credit and debit card transactions, checks and bill payments. These likely would be even more damaging to economic activity.

The financial services industry should continue to resist the financial transactions tax, even at the proposed low rate. Once the camel’s nose is in the tent, the whole camel soon follows.