Tags: Bank of America, Citigroup, Credit-Default Swap, Goldman Sachs, JPMorgan Chase, Martin Hutchinson, Morgan Stanley, Taxes, Tobin Tax, Trade, Wall Street

The Tobin Tax: The Deficit-Busting Levy Wall Street Hates

[Editor's Note: When it comes to explaining how politics feeds off business, Money Morning's Martin Hutchinson is unmatched. Months before the actual events, Hutchinson correctly predicted the outcomes - and the investment impact - of the U.S. presidential primaries and the general election. More recently he's turned his attention to the looming U.S. midterm elections, the debate over the Bush tax cuts, and plausible deficit-reduction strategies.]

By , 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."

Picking the Right Tobin-tax Rate

The Tobin tax, proposed by Nobel laureate James Tobin in 1974, would tax transactions of all types - including those in the stock market, on foreign exchanges, in the derivatives market, or even possibly in the mundane daily transfers we use to pay our bills.

Some commentators have suggested instituting a broad-based Tobin tax at a rate as high as 1%. I think that's very unlikely, since it would be hugely damaging to life in the overall economy.

Permit me to illustrate.

In the consumer economy, a tax at such a high rate would suck appreciable amounts of money out of every transaction we undertake - $3 out of a $300 grocery bill, for instance. It would also ignite a major move back to using untraceable cash - a huge boost for the illegal "black economy," and a major loss in efficiency and security (if people took to carrying their monthly paycheck around with them in $100 bills, the returns to theft would soar).

And in the face of such a high-rate Tobin tax, Wall Street would watch as the derivatives market and other key businesses were either forced offshore, or shuttered outright.

Politicians may not be all that smart, but the economists around them are not completely foolish. They are capable of seeing that the economic damage such a tax might cause would hugely exceed its yield, which in any case would be depressed by evasion. So I think a Tobin tax at such a high level is unlikely.

However, a Tobin tax at a low rate - perhaps 0.01% - is a different matter. Even if this tax were extended to all transactions in the economy, it would have only a small effect on most of us. Someone with a $70,000 after-tax income, for example, receiving pay-slips net of tax, would have total annual transactions - including credit card spending, withdrawals of cash, and other recorded actions - of less than $100,000. Thus, that consumer would pay an annual tax of no more than $10, which could be painlessly extracted by computer. (It would also be possible to exempt "retail" banking and credit-card transactions from the tax.)

The Tobin Tax Meets Wall Street

For Wall Street, however, things would be different. Most affected would be the "high-speed trading" business, which has investment banks set up powerful computers in the same building as the stock exchange.

This co-location and fast access to the "tape" of trades - coupled with some powerful computer algorithms - allows the institution to take crucial advantage of the finite speed of light and switching systems to front-run the market.

The margins on this business are very slim - as little as a penny or two a share on a $20-a-share trade. So even a 0.01% tax rate, costing 0.2 cents per share, would reduce those margins substantially.

At the same time this business is very profitable, earning Wall Street in excess of $20 billion in 2009, with the leading firm, Goldman Sachs Group Inc. (NYSE: GS), reaping perhaps $5 billion of this total. Thus, even at the aforementioned 0.01% rate, the Tobin levy would tax 10% to 20% of this profit, generating $2 billion to $4 billion in revenue all by itself.

The Tobin tax would have a similar effect on the derivatives market. The current nominal total of derivatives contracts outstanding was $542 trillion in December 2009. Since many of these are short-term in nature, we can assume that the annual trading volume is equal to least this amount, with the netting of contracts between the major houses probably increasing it further. A 0.01% Tobin tax, which would have to be imposed in all the major financial centers to catch the full flow, would thus yield about $54 billion per annum in tax revenue, of which perhaps $15 billion to $20 billion would accrue to the U.S. government.

You can see why the major banks are more afraid of a Tobin tax than of any other levy, including a tax on liabilities: It hits them directly in the nexus of their oversized trading activities. But few of these trading activities offer any benefit to the economy. In a global economy with a total output of $70 trillion, nowhere will you find $542 trillion worth of risks that need to be "hedged."

The major international banks - and Wall Street in general - are simply "rent-seeking;" that is, extracting profits out of the global economy while offering nothing in return. That's another reason to really like the Tobin tax: It would reduce the size and trading speed of both "fast-trading" and the global derivatives market, would raise revenue from this activity and reduce its volume, benefiting us all.

A Tobin tax would raise from $500 million to $1 billion from Goldman Sachs on its fast-trading activities, perhaps an additional $2 billion from its derivatives activities, and additional amounts from its foreign-exchange transactions, bond sales and other businesses - perhaps $4 billion to $5 billion in all. That money would bring about a commensurate reduction in the bonus pool that's used to reward the Goldman Sachs partners.

I'm not much of a class warrior. But if you ask me whether I'd be prepared to pay $10 a year to reduce the Goldman Sachs partners' bonus pool by $4 billion, while improving the world economy overall, I have to say I'd be happy to do so.

Wouldn't you?

Actions to Take: Take the time to familiarize yourself with such key (and surprisingly timely) topics as Tobin tax basics, high-frequency trading, the so-called "Bush tax cuts," and the very real dangers facing this country because of the huge budget deficit and hefty debt load that the United States must somehow address. What you'll discover is that a reasonably set Tobin tax offers one of the best options - and at the lowest cost to economic growth.

Once you've also reached this realization, take the time to contact your elected representatives at both the state and federal level, and make your thoughts known.

[Editor's Note: Why is it that Money Morning's Martin Hutchinson has been right on the money with every one of his political predictions for each of the last three years?

The answer is quite simple. The same skills that made him a successful global merchant banker - where he was easily able to identify winning trends for his clients - also make him one of the very best political prognosticators.

Just look at some of his most recent global predictions. Earlier this year, just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns - and one is up nearly 25%. He again recommended Korea - which analysts were downgrading - only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.

A longtime international merchant banker, Hutchinson has a nose for profits instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll find the time well spent.]

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