New Dem Tax for Speculators Will Hurt Individual Investors

Some Democrats in Congress and their Big Labor allies at the AFL-CIO are pushing a tax proposal intended to reduce stock market speculation. The tax, sometimes referred to as a “Tobin Tax”–although it differs in important ways from the tax on international currency speculation that Noble laureate James Tobin proposed  in the 1970s—would place a charge of about 10 cents per $100 on every stock transaction.  The idea sounds good in some respects but it would actually make things much, much harder for individual investors.

The tax’s proponents actually have a few decent arguments in its favor. Average investors in individual stocks would not really feel the impact from the tax — deep discount retail brokers like E-Trade and Scottrade would probably just eat the tax amount on most trades — and tax would, nonetheless, raise a significant amount of revenue. Volatility of some stock prices (which, some would argue is bad) would also decline. The most direct, immediate consequences, furthermore, would be felt largely by the wealthy who engage in large scale speculation.

But the tax would have one enormous downside for average Americans: many exchange traded funds (ETFs) — mutual funds that trade all day long on stock exchanges and charge rock bottom management fees — would become nearly impossible to sell quickly and would probably vanish from the market. ETFs, by virtue of their low fees, have become a very popular vehicle for individual investors and are found in about a third of retirement plans (more than half of those newly opened). As with other mutual funds, they are designed to be held for the long term. In fact, because buying and selling them involves up front commissions, they’re superior to ordinary mutual funds only if held for a reasonably long time.

Speculators, however, make it possible for the funds to exist and make the market for selling them. A very common hedge fund strategy involves buying both an ETF and the stocks that it contains. The fund them attempts to make money by exploiting tiny differences between the value of the fund and the underlying stocks. (Traditional mutual funds price only once a day making this strategy much harder to work out with them.) Thus, hedge funds and other speculators make ETFs liquid. Even a tiny tax on this type of activity would probably make it more-or-less impossible for hedge funds to provide ETF liquidity. Individual investors might still provide liquidity for very common ETFs that track things like the S&P 500 but large numbers of people would be stuck with valuable assets in their retirement plans that would be very difficult and expensive to sell. Thus, the proposal seems likely to harm lots of small investors.

The “Tobin Tax” being proposed imposes transaction costs for no valid reason. It’s an awful idea.