As part of their presidential nomination campaigns, Bernie Sanders and Martin O'Malley both have proposed a financial transaction tax, designed to tap a lucrative source of revenue and target trading abuses on Wall Street.
Pension funds and other tax-exempt asset owners, even though they generally don't pay taxes, would pay this tax like other investors. But even if Congress exempted them from the transaction tax, they could not escape its consequences. They would still bear the brunt of the detrimental market impact of the tax, such as declining liquidity, and they would pay the price indirectly as money managers passed their increased trading costs through to clients.
Asset owners and other institutional investors must step up and raise their voices to oppose such a tax because the damaging consequences on the markets, and market participants, would more than offset the projected revenue and benefits of any market reform.
There is no evidence that supports the implementation of such a tax as an effective revenue raiser or as a correction for market failures. Even so, on the campaign trail and in Congress the appeal of tapping a new revenue source, especially one related to a reviled Wall Street, has a way of gaining traction.
Without any pushback from fiduciary investors and others in the institutional investment community, swelling support on the campaign trail, especially the enthusiastic crowds cheering Mr. Sanders, could put pressure on Hillary Clinton, the Democratic front-runner, to embrace a financial transaction tax as part of her campaign platform.
Asset owner fiduciaries must emphasize that financial transactions serve valuable economic and social purposes. Transactions aren't an incidental, unnecessary component of investment to raise Wall Street's share of income without adding any value to investment portfolios or the economy.
For asset owners, transactions serve an important, useful function of investment management, and contribute to securing income for retirement or other spending priorities. Transactions facilitate the flow of capital, including raising funds to finance business expansion or government infrastructure projects, allocating resources in the best way to expand economic activity, including employment, and adding value to investments of asset owners as well as facilitating necessary liquidity for them.
If you tax something, you get less of it, meaning less trading and hence less liquidity in the market.
Because asset owners know the significant adverse impact unnecessary transaction fees have on their investment returns, they keep a tight watch on them and adjust activity to keep them as low as possible.
Messrs. Sanders and O'Malley, and other proponents of financial transaction taxes, fail to recognize these important characteristics. But they deserve credit for one thing: for presenting a specific proposal in their campaign platforms and seeking a mandate for it, should either be elected. Only six of the field of 22 candidates — five Democratic and 17 Republican — have so far presented specific tax proposals, according to a report by the Tax Foundation, Washington.
Up to now, only Messrs. Sanders and O'Malley have proposed a financial transaction tax. But the presidential campaign is still in its early stage.
Their tax framework targeting investments is not far from what Ms. Clinton has proposed as part of her campaign. Her proposal significantly raises short- and long-term capital gains taxes. Tax-exempt asset owners don't pay capital gains taxes. But an increase in such taxes would have a detrimental effect on capital formation, the economy and employment growth by indirectly raising the cost of capital to corporations as taxable investors seek to minimize the impact.
Mr. Sanders' proposal, introduced in the Senate as S 1371, as well as a proposal by Rep. Keith Ellison, HR 1464, in the House of Representatives, both on May 19, are called the Inclusive Prosperity Act and are pending in their respective legislative chambers.
Both bills would apply the tax, generally 0.5% of the value of the assets, or 50 cents of every $100, in every transaction involving equities, 0.1% on bonds, and 0.005% on derivatives and currencies, among other financial instruments. Their bills exclude municipal bonds, an implicit acknowledgement by proponents of the adverse impact on trading by investors in these investment instruments.
The AFL-CIO and National Nurses United, an activist union of registered nurses, embrace the tax. The NNU estimates the tax would raise $350 billion annually.
The tax appeals to its proponents because it is not transparent to the average voter. But its costs and impact on the markets will be notable to institutional investors, including increased administrative costs for compliance, increases that will be passed onto clients.
Such a tax has tremendous economic consequences, according to a joint statement reflecting the views of more than two-thirds of participants in a Financial Economists Roundtable in 2013 and published in the January/February 2014 Financial Analysts Journal, a publication of the CFA Institute. “Lower asset prices would cause decreased corporate investment, resulting in less capital per worker in the long run and thus lower wages throughout the economy,” said the FAJ article about the discussion.
With the ease of trading in global markets, institutional investors with the resources would shift their trading to other venues to avoid the tax, while investors without the wherewithal or ability to do so would bear the full impact of the tax.
The tax's impact on investment could compel pension fund sponsors, private and public, to raise contributions to offset the costs, direct and indirect, associated with it.
The tax probably won't raise as much revenue as proponents expect, or eliminate high-risk behavior on Wall Street or excessive market volatility. It will affect routine trading as much as high-risk trading. An asset owner trading 10,000 shares of General Motors Co. to raise cash to finance monthly pension benefit payments would be taxed as much as a high-risk trader engaged in excessive activity. The tax will distract attention from addressing real challenges of trading abuses and volatility.
Other countries that have enacted such a tax have repealed it because it has been ineffective in achieving the goals. In Sweden, for example, where such a tax was introduced in 1984, revenues were disappointing and the negative effects on both stock and bond markets were great, causing the tax to be repealed in 1991. But that hasn't stopped countries from imposing the tax and others from planning to introduce it. Eleven countries in the European Union plan to impose such a tax next year.
With the idea of the transaction tax picking up proponents in this presidential campaign, asset owners and other institutional investors must set out on their own campaign trail, opposing it because of its detrimental consequences.
