The Tobin Tax: The Fix-It Plan Wall Street Hates … But Can't Seem to Kill

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German Chancellor Angela Merkel recently came out in favor of a "Tobin tax" – a small tax on financial transactions, proportionate to the size of the transaction. The Tobin tax idea also has been proposed by Britain's former prime minister, Gordon Brown, and was proposed in Congress by U.S. Rep. Peter DeFazio, D-OR.

Every time a Tobin tax is proposed, it has failed to gain traction – which isn't surprising: Wall Street, with its international affiliates and legion of lobbyists, hates the idea.

Even so, the Tobin tax idea just refuses to die – which is a good thing, since it is probably the best way of curing some of Wall Street's pathologies.


The Lowdown on the Tobin Tax

When the trading tax was proposed by the Nobel Prize-winning economist James Tobin in 1974, it was supposed to be applied to foreign-exchange trading – the arena that boasted the world's largest trading volume at the time.

A resolution to this effect was introduced in Congress in 2000 and a similar resolution passed the French National Assembly but was defeated in that country's Senate. At that time, it was considered a standard leftie gambit, an effort to raise revenue from the unpopular financial industry with which to fund beloved liberal causes. It ranked with ideas such as a levy on excess bank profits, which appeared to increase costs in the financial sector without any obvious benefits.

That changed with the 2008 crash, which revealed the ways Wall Street makes money. Since that time, Tobin tax proponents have relied upon these two rationales to push the levy:

  • A wish to recover some bailout costs from the financial-services sector.
  • And a more intellectually coherent belief that the Tobin tax might address some structural problems in the sector and in the global economy as a whole.

The first argument, to my mind, is still feeble – and even a bit vindictive. But the second argument has become pretty convincing.

In the three decades since Tobin unveiled his tax idea, the trading volumes in markets and on securities of all types have soared, reaching levels that weren't even conceived of back then. Wall Street, its allies, and its minions tell us over and over that we all benefit from this because of greater liquidity.

But we know that's not entirely true.

As a retail investor in the early 1980s, the reality was that I could buy and sell stocks on slightly lower spreads than I can today. Institutional investors have benefited, but this has just caused them to trade in and out like madmen – instead of becoming the steady, long-term shareholders that are needed for corporate governance to work properly.

In any case, around three quarters of stock trading is now characterized as "fast trading," and is carried out by computers located physically in the stock exchange, to get information about trading patterns faster than the rest of us. There are three things wrong with this:

  • First, since the rest of us don't have trading fingers that can move in milliseconds, three quarters of the trading is being done in a kind of private conversation, with outsiders – especially retail investors – not invited.
  • Second, computer-trading makes markets much more volatile. The algorithms used to generate it are faulty, just like the algorithms used by Wall Street on its risk management, so every now and then something happens that the computers don't like and the markets go cuckoo. The 1,000-point drop in the Dow Jones Industrial Average that took place in mere moments back on May 6 was just one example of this: From what I can see, it could just as easily have been a 5,000-point drop. For a computer, a minute is a long time – an eternity, even – and is certainly enough time to do 60,000 trades, or so!
  • Third – and most important – fast trading is "rent-seeking." Indeed, it is trading on "insider information," which in other forms is illegal. For instance, ever since the stock-market reform that took place back in the post- Great-Crash 1930s, it has been illegal to trade on insider information about next quarter's earnings. Well, information about trade flows, if you have it while the rest of the market doesn't, certainly qualifies as rent-seeking, and trading on that information equally qualifies as rent-seeking – since you are scooping value out of the market while giving nothing in return. You can't make it illegal, because if you did the function of market maker/specialist would become impossible, but technology has made that loophole in our laws much larger and more profitable. Profits from "fast trading" in 2008 have been estimated at $21 billion, and the business is expanding rapidly. With around 20% of the market, Goldman Sachs Group Inc. (NYSE: GS) is presumably making about 20% or more of this.

Tobin Tax Advantages

The principal advantage of a Tobin tax is that it would reduce the profitability of "fast trading." That's because the tax – while low on normal trading – would represent a high percentage of the profit on fast trading, where each profit is tiny and the computers make it up on volume. A tax of even a penny or two a share wouldn't affect normal investors – or even traders – very much. But would take a lot of the profit out of high-speed trading, thereby relieving the hidden tax that trading imposes on the rest of us. It would also yield a lot of money to set against budget deficits, while costing the rest of us very little.

Of course, that's why Wall Street hates the Tobin-tax proposal, and fights it every time it is proposed. The Tobin tax won't stop all their games – the margins on credit default swaps (CDS) are so high that a Tobin tax would affect them only modestly – but the benefits to markets would nevertheless be huge.

The impact on those controversial Wall Street bonuses also would be huge – a key reason the tax will be strongly resisted by lobbyists. But with support from countries like Germany and perhaps Japan – victims, rather than leaders, in the financial-services revolution – it may nevertheless pass in the end. Wall Street will threaten to move its trading offshore, but if the major economies agree to a tax, the big institutions will effectively have nowhere to go.

For us as investors, other than cheering on the Tobin-tax movement, there are few direct implications. Still, you may want to sell your shares of Goldman Sachs Group Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), Citigroup (NYSE: C) and Bank of America Corp. (NYSE: BAC), as well as any other trading-oriented financial institutions.

In the long run, one of Wall Street's most lucrative – but damaging – games may be history.

[Editor's Note: Money Morning readers are often amazed by Martin Hutchinson's profit-focused instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show us the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

So it's no surprise that Hutchinson has pulled off a string of forecasting successes in the face of the worst financial crisis since the Great Depression - a financial crisis that, not surprisingly, Hutchinson is widely credited for having predicted and warned about well ahead of time.

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  1. DEE | May 27, 2010

    The Tobin tax…just government wanting to profit from free trading. Wouldn't it just be better to regulate the minimum time that a stock must be held. For example, one minute, one hour, or one day…that would do the same thing, and the govenment wouldn't have to tax anything.

    • Jeff Pluim | May 27, 2010

      I am a small investor, compared to the banks, and I would not want anyone to hold up my money for any length of time. What happens if the stock that I just bought starts to tank? If I cannot access my money, sell that stock, then I can only watch as my investment drops. That is hardly fair, and it infringes on my property rights. I would not have a problem paying a Tobin tax if I have access to my money when I want it.

  2. Tom Jackson | May 27, 2010

    Wow, a tax that is good for us, I guess more of this business world changing in a way that is strange. My question: insider trading is illegal I still do not understand why since it is men who write the programs that do the fast trading are exempted from this being illegal. Is it not still men manipulating the system with insider information? After all if you and I are to drive say the New Jersey Turnpike to recieve a bonus for doing it the fastest and my vehicle will go so fast that no system can clock it or stop it in route, does that mean I broke no speeding laws in getting the advantage and recieving the bonus? After all it is the machine that made the trip so fast not me. You see gentlemen, our first problem is giving politicians more money.

  3. A. Pearsall | May 27, 2010

    For once I agree with Mr. Hutchinson wholeheartedly.

    Except for his criticism of some of the support for a Tobin tax as being perhaps "vindictive."

    After the last several years, God forgive me but where the banks and the insiders of Wall Street are concerned….I do feel vindictive.

  4. JJ | May 27, 2010

    What we really need is absolutely flat taxes,with the same % no matter what the income.That way the idiots paying no taxes and supporting all kinds of govt programs would start paying for them.Would encourage them to stop supporting wasteful govt.Also,a low flat tax would rid us of all the money wasted on tax preparation and lower tax avoidance and tax evasion.Otherwise consumption taxes would be better.My guess is that govt will continue just printing it's way out of debts.

  5. Mike Gallagher | May 27, 2010

    Dear Dee,

    Only taxing the trade each time will have any effect that would impact traders. a holding period would be finessed by simple algorithms in the programs and probably lead to more not less trading. Besides the idiocy that a government is to run without taxing any activities of the governed is an idiotic chant of fools and most dumb Republicans.

    • traderpards | May 27, 2010

      Mike,
      The straw man knows no bound. Really, "dumb Republicans" believe government shouldn't tax "any" (your words) activity "in order to run"? (Again, your words.) The idea that government gets stronger the more it taxes and whose economy suffers no repercussions as a result of those taxes is an idea that is shared by mostly dumb Progressives.

  6. traderpards | May 27, 2010

    It isn't going to be a penny a share. It is NEVER what they say it's going to be in fact, Fazio proposed .25 percent of the trade – not the profit – the gross amount of the trade!! Both ways!! That indeed does affect us traders. Never, never, ever, ever trust the government to do what they say they will do.

  7. M. Perkins | May 27, 2010

    It seems unlikely to me that anything so reasonable would get past Congress, what with all the money and political pressure arrayed against it.

    How about this idea: Since those obscenely humongous bonuses were essentially thefts from shareholders, why not find some way to assure that shareholders have first call on profits?

  8. Martin Pekarovic | May 27, 2010

    Applying Tobin Tax against account's fast flipping, over say $1 million worth of trade a shot, I find beneficial for small investors and should progressively increase with growing amount of worth of transaction. Terms like speed trading, one account trade, would have to be carefully outlined to avoid creative loopholes to succeed. Proceeds from these fees would go strictly to say tree areas, progressively, as they build up: The currency would be backed in precious materials(again), old citizens would be taken care for – starting with oldest, poorest and loneliest. Finally, the fund would be created in the fashion of biblical Joseph in Pharaoh's Egypt: Money for the disaster times, emergencies of all kinds impacting population, including dry seasons, when food availability, jobs, economy, pandemics and enemies scares are pounding populus. I believe, slowing down mindless trading activity would benefit majority of the society. Nation would be more stable, more prosperous, safer, happier, looking forward to future. I would declare illegal to impose any debt on nation by any government, period. And I am not even living in the U.S.A. or being a citizen of this country going through trials and being called to take stance on the true American dream. God bless You all…

  9. Martin Pekarovic | May 27, 2010

    TYPO: not …"tree areas", but …"three areas". Thanx.

  10. DEE | May 27, 2010

    Mike Gallager,

    Thanks for your totally idiotic reply…

    What service is the government provided here–other than taxing an activity that does not need government interference. If it exists–tax it…must be government had a hand in creating it–that's clearly the Democrat's chant. If investors aren't smart enough to deal with the ups and downs of the market–just stay away!

  11. Hugh Klein | May 28, 2010

    Voice to sell financial securities, should appear in every media across the US of A.

  12. Tom T. | May 29, 2010

    The Tobin tax spin is just another example of how politicians succeed in fleecing the population. This is a "good tax" they are saying, as it will hamper fast trading. What they are not saying and not doing is anything that stops the bloody corruption that enriches them.
    This is equally true for both Republican and Democratic party members with rare exceptions.
    Fast trading is simply allowing the select few to view incoming trades, and step in line front of them to take the spread. What's so difficult about calling a spade a spade?
    Now we have a supreme court enabling no limits on corporation spending in lobbying elected officials and funding campaigns and advertising to influence political outcomes. Do you really think this is ok too?

  13. Brian | May 30, 2010

    "A tax of even a penny or two a share wouldn't affect normal investors – or even traders – very much." Oh really, Martin? Multiply that over hundreds of trades/year for us "normal" investors or traders and you can see where this is going. For example, if you only made 200 trades/year (I make far more than that, but I'm being conservative) and traded 100 shares/trade, that's $400 @ .02/share. And you pay that to our wasteful govt whether you made a profit or not. 1000 trades/year, trading the same 100 shares, (about 83/month–think day traders) would set you back $2000. I don't think so.

    I don't think you've thought through the implications of this very carefully, Martin. In your misguided effort to stick it to the speed traders, you will run the small trader out of town right along with them, and liquidity will vanish from the markets. Day traders would be ruined. Government has no business meddling in the capital markets in any way, shape or form.

  14. Don Fishgrab | May 30, 2010

    Simply charging the tax would force financial institutions to review their activities, thus helping control the problem. If the rest of us have to pay taxes on every transaction, it is only fair that those involved, who make profit from them do likewise.

  15. alexandru semenciuc | May 31, 2010

    Angela Merkel and her Germany it is the samne bitch as usual . This hitleriste woman is the ruin of Europe . Europe is now invaded and submited(ensclaved) by the Germans again. Whi will free Europe from that brown plague of the XXI century

  16. David Dzidzikashvili | August 25, 2010

    Interesting idea, very interesting proposal, but I think it needs further research on what results it will produce. There are always results and effects produced by new taxes/laws/policies that no one ever expected, some good, some bad (mostly).

    As a member of political center, I am not in favor of any new taxes, but I do support curbing Wall Street power, reducing risk and moving to more conservative fiscal policies…

    If the Tobin tax will do exactly that and ONLY THAT (with no other effects produced) – decrease overall risk for the economy and average investors (and also indirectly curb Wall Street political power & influence) – then I am all for it, since this would help the Middle Class, Main Street…

    Let's have the Germans, Japanese the French do it as a micro demo test on their economies, lets monitor and see the results. If the tax does what it was intended for then we can initiate similar laws in the US, but lets not make senseless/quick decisions…

  17. Jane O'Brien | February 14, 2011

    There's also increasing support for a Tobin Tax to be introduced in Ireland now, but no-one can agree on the issue
    .

  18. Daniel Goodman | April 4, 2011

    hey I liked that post…It was really a help…
    any way for blocked funds..I know a company called Blocked Funds..Dose any one know about it

    Regards
    Daniel Goodman

Trackbacks

  1. [...] By Martin Hutchinson, Contributing Editor, Money Morning After the Nov. 2 midterm elections, the Obama administration and Congress are going to have to scramble to fill a trillion-dollar hole in the U.S budget, and tax increases may be the only option. A tax increase won't be good news for an already wheezing economic recovery that seems to get weaker with each new report or indicator that's issued. But the type of tax that's chosen will go a long way in determining just how much damage the U.S. economy will have to endure. With a deficit in excess of $1 trillion, there aren't a lot of options. One possibility would be to allow the 2001 and 2003 Bush tax cuts to expire, which would have a depressing effect on the economy and most people's pocketbooks. But a better option would be to devise some new taxes that may prove less damaging. Indeed, there's even one possibility that might even do some economic good if it's implemented correctly. It's called a "Tobin tax." [...]

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