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Financial Transaction Tax Punishes Main Street more than Wall Street

Representative, Peter DeFazio is at it again.  With support from Senator Tom Harkin, the two US lawmakers have introduced a bill to propose a tax on financial transactions. 

DeFazio tried to propose a similar tax a couple of years ago, but the proposed bill never gained much traction.  But now that the European Union has proposed a financial transaction tax, DeFazio is hoping that his proposal can gain more support this time around.

Their argument is that this tax would generate a substantial amount of revenue, at the expense of Wall Street, which can easily bear the tax. But upon closer examination, who does this tax actually punish?

In theory, this tax would raise a substantial amount of revenue. However, it would come with some substantial costs, the most significant being a decline in market liquidity.  Market liquidity refers to a stock's ability to be sold without substantially impacting price.  The majority of our market liquidity is provided by market makers.  These market makers (some being high frequency trading firms) have very small profit margins.  A modest transaction tax of 0.03 percent (which is being proposed), would have drastic effects on the market making business.  Let's take a quick look at the math.

Many of our most highly traded stocks have bid-ask spreads of one cent.  A stock that is trading at $25, would have a transaction tax of ($25 x 0.0003) = $0.0075 per share.  If a market maker were to buy this stock at $25 and sell it at $25.01.  They would make 1 cent/share, but would have to pay 1.5 cents/share in tax (they have two transactions, the buy and the sell).  Therefore they would lose 0.5 cents on the transaction.  In order to remain profitable they would have to widen their spreads to a minimum of 2 cents, and possibly further (as market makers aren't always profitable on every trade).  Wider spreads means more price impact for institutional traders as they make trades, and this added expense comes right out of the pocket of the individual investor who invests in the fund that is trying to transact.  The bottom line is that market makers (some being high frequency traders) are still going to make money, they are just going to trade with wider spreads in order to do it. This is an indirect cost to Main Street, not Wall Street. 
The direct cost is that the institution transacting would have to pay the transaction tax as well.  So another 0.03 percent comes out of the pocket of the individual investor investing in the fund, every time the institution makes a trade. This number may sound small but imagine an institution that trades 200,000 shares of a $50 stock. The transaction fee on that transaction alone would be $3,000. Many actively managed funds trade much higher volume than that in a single day. These costs would quickly add up, again punishing Main Street.

What would naturally happen is that institutions would become hesitant to trade, and may hold onto a position they would otherwise sell, just to avoid paying the transaction fee. This could lead to large losses in positions that may have otherwise been liquidated. Who would bear the brunt of these indirect costs? Main Street again.
The benefit to this tax would come in the form of the revenue generated from the tax. But trading volumes would drop substantially, as traders and institutions seek to avoid excessive taxation.  This makes any projected revenue raised by the transaction tax much less than what would be raised on today's current market volumes.  The revenue raised from this tax would pale in comparison to the costs mentioned previously. 

So I would argue that Wall Street would not bear the brunt of this tax. Wall Street traders will simply evolve to the new environment by widening their spreads.  In the end, Main Street will pay.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.