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Would Transaction Taxes Really Send Wall Street Abroad?

Recent CBO findings to the contrary, the U.K.’s experience suggests the banking industry is blowing smoke on the risks posed by a financial transaction tax.

With the European Union likely to proceed with the implementation of a financial transaction tax in the New Year, the question is whether a similar levy in the United States can survive the anti-tax fervor that seems to be sweeping the country.

Senator Tom Harkin, an Indiana Democrat, and Rep. Peter DeFazio (D-OR), have introduced a bill calling for a Wall Street Trading and Speculators Tax Act. It would impose a .03 percent tax on financial transactions, equal to about $3.00 for a $10,000 trade. The congressional Joint Tax Committee reckons the tax would raise about $350 billion between 2013 and 2021, or about $41 billion a year in its final years.

“We worked with economists and said where is the point where we are creating significant revenue and we’re not having a detrimental impact on long-term value investing, pension funds and mutual funds,” DeFazio said in an interview. He said such a tax would curb rank speculation, which has been a curse of the stock market of late.

But the idea was dealt a severe setback when the impartial Congressional Budget Office issued a report last week in which it was suggested such a tax could have a significant negative impact on the U.S. financial industry.

“Because of economies of scale in trading markets, as foreign holders of U.S. securities moved their transactions abroad, more of the market could go with them, which could diminish the importance of the United States as a major global financial market,” wrote Douglas W. Elmendorf, the CBO’s director. Elmendorf conceded that the negative impact he predicted would be blunted by other nations adopting a similar tax. “That effect would be mitigated if other financial centers introduced their own transaction taxes,” he said.

The financial services’ industry has always opposed imposition of a transaction tax, saying it would “impede the efficiency of markets, impair depth and liquidity, raise costs to issuers, investors and pensioners and distort capital flows by discriminating against asset classes.” Even President Obama has been cool to the idea of such a tax in his negotiations with other members of the G20. Without White House support and the implacable opposition of the Republicans who control the House of Representatives, the tax stands little chance of adoption by 2013.

DeFazio maintains that the CBO based its findings on academic research that he said was flawed because it is based on very small samples. More than 30 other countries have some form of financial transaction taxes and it doesn’t seem to have dramatically affected trading.

Notably Singapore had a tax on financial transfers for many years and still has a value added tax on share transactions, yet it remains southeast Asia’s financial hub. Even the U.K., which is one of most outspoken opponents of such a tax, still maintains .5 percent stamp duty on share sales. Some critics maintain that has prompted traders to focus more on options than equities, yet the tax is still a big revenue producer for Britain.

France and Germany plan to present a joint proposal for a financial transaction tax on Jan. 23. It will be based on the proposal made in September by European Commission president Jose Manuel Barroso. It would impose a tax of .1 percent on financial transactions, raising an estimated $78 billion a year. The proposal is widely popular in Europe, where many people blame the financial industry for the current economic crisis.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who is one of the co-designers of the U.S. tax proposal, concedes that it would negatively affect the financial services industry initially, but he maintains the damage would not be long-lasting or widespread. “If we really are concerned that the financial industry would move offshore, we could do a lot to prevent that," Baker says. “All the evidence suggests we’re talking about a small amount. Someone should tell the U.K. they are going to lose their entire industry because they have had a tax for 315 years.”

Bakers says the main thing the U.S. could do to prevent large scale defections overseas is to encourage other countries to adopt a similar tax, which would limit an investors’ options when it comes to moving transactions offshore.

Baker says that research on transaction costs and volatility suggest that in the short-term, volatility would rise because it would raise the cost of arbitrage. It would also reduce profits for high-speed, low-cost traders. But he adds that it would likely reduce the chances of another Flash Crash taking place because trading profits would be reduced on very short-term trades.

Baker says that transaction costs have come down dramatically in recent year so that increasing those costs will not have a major impact. “The impact on liquidity is going to be very small,” he says.

“Obviously the financial industry hates it, because it’s pretty much dollar for dollar out of their pocket,” Baker says. Financial houses in London "would love to see it gotten rid of, and the last thing on earth they want to see is to have it extended further.”

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