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Bring On the Tobin Tax – But Only After Making This One Key Fix

The European Commission (EC) on Sept. 28 proposed a Tobin tax for the European Union (EU). It's likely to pass, in one form or another, but it won't stop there.

The United States will be next – and as investors we should be grateful. I just hope policymakers make one key change first.

I'll explain.

I penned a column for Money Morning almost exactly one year ago that said major world economies should adopt a "Tobin tax" – a small tax on financial transactions, named after its inventor, Nobel laureate James Tobin.

It's always nice – albeit unusual – when politicians take my advice. And I'm certainly glad that the EC is doing just that. But the commission still hasn't gotten it quite right.

A Promising Proposal

You see, the Tobin tax I proposed would be at a very low rate, perhaps 0.01%. Apart from raising revenue, its main effect would be to inhibit speculation. By that I specifically mean "high-frequency trading," or HFT, where computers trade bonds, stocks, and derivatives in milliseconds.

High-frequency trading is objectionable for two reasons.

First, its proponents claim it provides liquidity to the market, but that's not really the case. In periods of turbulence, the liquidity that HFT supplies is quickly withdrawn, as the institutions operating the trading systems shut them off for fear of large and destabilizing losses. Indeed, liquidity that switches off when it is most needed is of no use at all. To the contrary, it destabilizes the market rather than stabilizing it.

The second reason high-frequency trading is bad is that it uses machines to get trade information before competitors. Of course, trading based on extra-fast knowledge of the trading flow should qualify as inside information, and thus be illegal.

Unfortunately, it can't be made illegal, because market-makers do it all the time. And what's more is that stock exchanges make huge sums of money by renting space within feet of the exchanges' computers to high-frequency traders.

And that brings us to the tragic flaw of the EC's proposal.The Tobin tax proposed to the European parliament by EC President Jose Manuel Barroso would impose a 0.1% tax on stock and bond transactions and a 0.01% tax on derivatives trades.

It's backwards.

A Tragic Flaw in the Tobin Tax

A tax rate of 0.1% on bonds and stocks is too high. It will prevent high-frequency trading, but it also will prevent legitimate arbitrage and market-making – thus making markets illiquid.

The tax makes even less sense for bonds, where profit margins at the short end are very skinny indeed. A tax of 0.1% is a gigantic problem for investors in one- and two-year government bonds whose yields are well under 1%. Indeed, money market funds would be wiped out entirely if the tax extended to really short-term paper.

And yet, derivatives are favored by a 0.01% tax, which makes no sense.

By definition derivatives do not finance real economic activity, because they are derived from real investments like bonds, stocks and commodities. So to discriminate in their favor makes derivative investments more attractive than bonds or stocks.

Moreover, at least some derivatives – notably credit default swaps (CDS) – are exceedingly damaging to financial stability as a whole. CDS played a big role in the 2008 crash. And even now they continue to wreak havoc by encouraging speculators to bet against Spanish and Italian government bonds, thus worsening the euro crisis.

The EC should look for ways to dampen down the CDS market. It should lower the tax on trading stocks and bonds to no more than 0.01% on bonds and 0.02% on stocks, and raise the tax on trading derivatives, perhaps as high as 0.05%.

It then needs to reach an agreement with the United States – maybe the entire Group 20 (G-20), in fact – to impose parallel taxes. An EU tax alone will simply drive trading activity offshore – although not, interestingly enough, high-frequency trading. In that case, relocating the trading computers to the Cayman Islands would mean a fatal 0.16-millisecond delay in the information flow!

Still, the Tobin tax is coming. And as investors, we should welcome it.

The EU tax – if imposed – is expected raise about $80 billion (57 billion euros) per year. That money will be split between the EU organization and its member states, which could certainly use it.

The United States could use a tax like that, as well. And it just might get one if the EU follows through.

Of course, you should avoid buying shares in the major trading houses like Goldman Sachs Group Inc. (NYSE: GS), Citigroup Inc. (NYSE: C), and Morgan Stanley (NYSE: MS). These banks already are in bad shape, and a Tobin tax could severely hamper their trading revenue.

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  1. Sandman | October 11, 2011

    Tobin Tax is a disaster & unworkable. You can't even get all the nations in europe to agree to it. Britain has rejected it. The US has rejected it. If the EU is idiotic enough to adopt it, business will just move to the venues that do not have it (London, New York). They will just make the deep financial hole they're in into the grand canyon.

    Tobin tax may be ok for stocks & bonds, but for derivatives & currency trades it is simply an oppressive abomination. If Mauritius doesn't have it, you'll find the currency trading moving to Mauritius.

  2. F W Danby | October 11, 2011

    We already have graduated taxes on capital gains, higher for short term holds than for long term holds.
    We need a substantial tax on ultrashort and very short -term holds – taxable **at source** by the computer doing the trade and proceeds immediately transferred to the US Treasury.
    Very short trades – less than one hour – 10% of gain (and credit of 10% of loss)
    Ultra short trades – less than 15 seconds – 50% of gain (and credit of 50% of loss)

    • Carolyn Wu | October 12, 2011

      Yeah, right, and when they lose and lose big, the US government will be on the hook for billions of dollars. It is better to simply impose the Tobin tax. Why should I care if you make (or lose) money? The point isn't to collect tax profits (which I will anyway), it is to discourage ultrashort term holds in the first place. At the same time, you don't want to tax them too heavily because the tax acts as a wedge on the arbitrage market. 0.01% is a reasonable total spread for currency markets. Thus, the proposal should be 0.01% for stocks, bonds, and currency markets. 0.05% for derivatives markets (which are much bigger anyway). However, I'd add one more caveat: a government can only get the revenue if it pledges (and actually does) maintain operational spending (i.e., everything except for interest on their debt) at no more than 20% of its GDP AND it balances its operational budget (i.e., if it had no debt, it would have a balanced budget). If it spends more than that, the money goes to countries that do reduce spending to that level based on the rule that those countries that have the higher operational surpluses get the money first, but only if the money goes to retire debt (reward those who are doing the right thing and getting out of debt). Any government that exceeds 20% of its entire economy is an abomination.

  3. Werner | October 11, 2011

    An EU – tobin tax can only be flawed, since it will be a socialist redistrivution tax and nothing more. You'll never see a socialist – be it Barroso or anyone else – proosing a reasonable tax. And I can still not see the Brits and the USA agreeing to such a tax, which will make it inapplicable. Better no tax than a bad one.

  4. Jerry Fahrmann | October 11, 2011

    I liked this idea when I first read it, and I do think it is time for us to have it in this country.

  5. malcolm | October 11, 2011

    WOW I think you are wrong and here is why. The hub of the EU financial market is the city of London . If this Tobin tax is introduced it is estimated that E70 billion would come from London . Do you seriously think the UK goverment would accept this .? They have the power of a veto on this and have already stated that they will use it.

  6. fallingman | October 11, 2011

    Barroso has it backwards? What a shock.

    That clown should be doing hard time for all the damage he's done.

  7. Rhone | October 11, 2011

    They way to fix the Tobin-FTT-Robin Hood Tax is the precise tax rate. How simple.

    So, you think you can distinguish between high frequency trading and market making. Why would a market maker pay any tax rate at all? How could they pay it? The tax is greater than the profit. The market makers would go broke after a low number of trades. And how long do you think that low rate tax will last? Sweden's disastrous experiment with FTT started with a 0.5 percent rate and raised it to 2 percent sometime later.

    Sweden's experiment with a broad-based and comprehensive transaction tax was short-lived. Government bonds had a rate of only 0.03 percent. Trading of bonds fell 85 percent the first week, bond futures trading dropped 98 percent, bond options stopped trading entirely. The Swedish government could not sell bonds to raise revenue. The Swedish government had predicted transaction tax revenue from bonds alone would raise 1.5 billion kroner. They got just over 3 percent of that. Revenue was net negative after economic losses.

    Why not just shut the markets down? We don't need them apparently.

    And equities and bonds and their derivatives had absolutely nothing to do with creating the financial crisis.

  8. Tad Renfert | October 11, 2011

    I think the tax might be okay if it only applies to those selling their positions the same day they bought them. This would get to the crux of the matter without punishing everyone else. High-frequency traders live on slim margins.

  9. Dwarden | October 11, 2011

    My understanding from the Economist is that London has not rejected the Tobin tax. They are only saying there must be agreement to use it in all major markets. That is why it failed in Sweden. If it is to work the major markets need a level playing field. Regarding rate creep, having international agreements on structure and rates would slow or delay changes. Their also needs to be some effective penalty structure for markets and players that don't follow the rules.

  10. Aprov | October 11, 2011

    I knew very little about the Tobin Tax, or the plans to implement it in Europe. I found this article about the Tobin Tax, and the discussion that flowed from it to be very informative. Thanks to all!! Regards!

  11. Scott Lowden | October 11, 2011

    Your transaction tax is getting a pretty rough reception on this board. It should. You are playing the old game of "just a tiny tax" on those "evil speculators" to save the "little guy". No unintended consequences, just a perfect targeted socialist tweak, right? And it'll bring in revenue to our underfunded government too! Golly whiz, trot this idea out to the airheads teaching our college students, not to the Money Morning readers.

  12. Lindtech | October 11, 2011

    There were no high frequency traders 20 years ago so why should there be now as they seem to be causing a great deal of damage to the market and various countries. Maybe they should find some honest work somewhere.

  13. Greg Czora | October 11, 2011

    You folks just don't learn do you? Both the US income and payroll taxes started out really low. Look at them now. But they wouldn't do that with THIS tax, would they? Naw…could never happen.

    Greg Czora

  14. JustCallOnTyrone | October 11, 2011

    @Rhone …derivatives had absolutely nothing to do with creating the financial crisis?!? Anyone who makes such a claim is either delusional or dumb.

  15. Angel | October 12, 2011

    Americans, particularly you independents, Today’s Vote proves that McConnell and Senate Republicans and two Demos Lester / Nelson as well as House Speaker John Boehner and House Majority Leader Eric Cantor and Kevin McCarthy had no intention of supporting any jobs for Middle class Americans! Americans are longer asking where the job is creating legislation in the House of Representatives that you promised last election. We are furious?
    According to Senator Bernie Sanders, it is now clear that the Republicans /hypocrites continue their pledges for their “only” plan of continuing its Class War against the Middle Class to protect their rich Millionaires and Billions like the Gover Norquest, Russ Limbaugh, Rupert Murdock and others like the Koch Brothers that provide them their campaign funds! Their plan was never about creating American jobs for the unemployed middle class! They proved that when they voted against unemployment benefits because they said you were too lazy to a job! This is a clear and concise recap of what is the real issue? American march on Wall Street to Stop the hypocritical republicans! 70% of Americans are disgusted with political prostitutes taking thousands of $$ from the same billionaires and Millionaires! Are you listening Mr. McConnell and Boehner, Cantor and your obstructionists? Another year of no taxes for Grover Norquest and his Billionaires and Millionaires for the called "job creators," but still no new jobs? What's the deal with the right wing clowns in Senate and House? In November we will remind you that It’s all about jobs stupid

  16. Rhone | October 12, 2011

    @Tyrone: Watch your mouth and or think. I said equities and bonds and their derivatives. Nothing that trades on the exchanges in the US had anything to do with the financial crisis. That includes equity, bond, etc. and equity derivatives, bond derivatives, etc. that trade on exchanges. Subprime trash derivatives, CDO's, MBS's, CDS's that helped create the crisis did not trade on exchanges. More than that, the government creating a real estate bubble did more damage than anything else.

    @Dwarden: the tax will fail if applied to all 195 countries, if you call failure as being the only ones to pay this tax are the individual investors and small businesses. Right now there are two choices if FTT is enacted. Move to a country without one or go out of business. Unless liquidity providers or market makers are exempt from the tax. If so, what is the point of the tax other than to tax individual investors. Lunatics.

  17. Sandman | October 13, 2011

    London Says NO:
    http://www.guardian.co.uk/business/2011/sep/28/barroso-backs-tobin-tax

    USA: Geithner & Chamber of Commerce strongly opposed:
    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a45uxLtxi3N8
    http://www.guardian.co.uk/business/2010/mar/11/us-chamber-commerce-tobin-tax

    Given a choice of London & NY as well as other US venues (CME for futures) with no Tobin tax, why would anybody deal with europe and its tax?

    Do Sarkozy & Merkel have a death wish?

  18. William Davison | May 16, 2012

    The UK has had a Financial transaction tax since 1808. In 1986 it became the Stamp Duty Reserve Tax, but only really applies to retail investors at a rate of 0.5%.

    "Because the UK tax code provides exemptions from the Stamp Duty Reserve Tax for all financial intermediaries, including market makers, investment banks and other members of the LSE,[81] and due to the strong growth of the contracts for difference (CFD) industry, which provides UK investors with untaxed substitutes for LSE stocks, according to the Oxera (2007) report, more than 70% percent of the total UK stock market volume, including the entire institutional volume remained (in 2005) exempt from the Stamp Duty"

    It raise about £3-4billion a year. The exemptions from the Stamp Duty Reserve Tax for all financial intermediaries, explains why the average stock is now held for seconds with HFT, instead days or months. HFT is more than liquidity its a private tax on investors, but they big Investment banks.

    HFT is turning the stock market into a Casino where the banker always wins. The performance of the Pension fund money invested in stocks has been so poor, that many investors have switched to property in instead of stocks and bonds. Property in the UK is now significantly over valued compared with stocks, but the distrust of the stock market is such, that retail investors continue to plough money into property.

    A Tobin tax at 0.01% on all transaction in place of Stamp Duty would cut retail investors costs and would be fairer. It would reduce of some the excessive speculation that benefits the banks at the expense of the many.

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