March 8, 2021

Opinion: A tax on financial transactions could rein in Wall Street’s greed

As in previous meltdowns, the crisis was ameliorated by a combination of Federal Reserve intervention…

As in previous meltdowns, the crisis was ameliorated by a combination of Federal Reserve intervention followed by a large fiscal stimulus package that stabilized the economy. While other crises — of public health and the real economy — may have clouded memories of last March’s financial crisis, it remains true that if the Biden administration is really serious about building back better, it will need to do something about our bloated and crisis-prone financial sector. The single most useful tool it could deploy in this effort would be a financial transactions tax (FTT).
An FTT is just what it sounds like — a small fee levied on each purchase or sale of stocks, bonds or other investable assets. For stocks, the right fee would be around 0.4% of the value of the trade. A well-designed FTT would vary the rate depending on the asset being traded to equalize the effective tax rate across different average maturities of these assets.
The point of such a tax is straightforward: to raise revenue and/or to reduce the volume of financial transactions. The best part of an FTT is that typical households are winners, whether the tax ends up being mostly a revenue-raiser or a volume-reducer. If revenue is raised, then it can finance public investments and expansions of the safety net. For example, the cost of providing universal, high-quality pre-kindergarten to the nation’s three- and four-year-olds — a policy that generates utterly mammoth social returns — could be fully paid for by an FTT.
The volume of financial transactions in the US economy is utterly staggering: The value of just all the derivatives traded in recent years is roughly $1 quadrillion (one thousand trillion dollars) per year, or about 50 times larger than the dollar value of all goods and services produced in the US economy in a year. Even a tiny FTT imposed on this volume of transactions could raise enormous amounts of revenue. For example, even with the liberal assumptions that an FTT will put an end to a very large volume of transactions, our estimates put the revenue potential of an FTT at well over $100 billion annually (in the same rough neighborhood as what the Congressional Budget Office estimates the tax could raise), and it could actually get closer to $200 billion.
If financial transactions are reduced, less of households’ investment income will be sucked away by abusive financial fees. Fees charged for active management of households’ savings in retirement funds account for a large part of the enormous increase in financial sector incomes in recent years. But this active management largely does not lead to higher returns for households on average. Instead, actively managed funds generally do not outperform broad market indexes. Some fund managers beat market averages while others lag behind. In short, the vast volume of financial trading that justifies these fees actually just leads to zero-sum outcomes: My retirement nest egg might grow, but yours is just as likely to shrink.

If investors could instead just invest in funds that tracked market indexes with no active management, everybody would get the average return and there’d be no need for financial managers to charge high fees to shuffle money around. On average, household incomes would rise by the exact amount of the fees that financial managers used to charge for the privilege of making zero-sum bets with other peoples’ money.

Research shows again and again that most households would see better returns on their savings if fees were lower — even if this meant that these accumulated savings weren’t so actively managed. So if the finance sector isn’t generating more wealth on average for households with their blizzard of transactions, is it doing anything else useful?

The standard story is that active fund management leads to better information and “price discovery,” which in turn can help more efficiently allocate the nation’s financial capital to finance productive “real” investments that build up companies’ factories and facilities. Faster real capital investment can in turn lead to faster productivity growth — how much businesses produce in an average hour of work. This would indeed be a benefit of more-active financial markets if it came to pass.

But this effect is awfully hard to see in the data. The macroeconomic data on business investment shows that this investment in both structures and equipment has not risen as a share of the economy even as financial transaction volume exploded since the 1970s. Productivity growth has been notably weak for most of this period as well. These two trends indicate that the huge growth in the financial sector in recent decades has not improved what is supposed to be its primary function — allocating capital to its most productive investments. Instead, we seem to have gone well-past the financial sector “tipping point” where more transactions harm, rather than help, overall economic performance.

If more transactions are failing to allocate capital efficiently, maybe finance is doing something else useful over this time — maybe using transactions to manage risk better? Given how utterly routine spectacular financial crises have become in recent decades, this seems highly unlikely. We have seen financial meltdowns requiring public interventions in the late 1980s, late 1990s, late 2000s and then, again, last year. Risk management has clearly been outsourced from private financial institutions to the public sector.

There is one indicator that has risen in near lockstep with the mammoth rise in financial transaction volume: executive pay and profits in big banks and financial institutions.

In the end, the huge rise in financial transactions in recent decades has added little to aggregate economic performance, has not improved investment returns or predictability for household savers (either directly or through the funds that manage their savings) and has mainly enriched the financial sector. The economy would be better off paying the financial sector far less to make far fewer of these zero-sum bets. It’s not always true that if you want less of something you should tax it, but in this case it makes sense.