The Impact of a Wall Street Transaction Tax

This legislation would mean disaster. Just think about it, currently trades for institutions on Wall Street cost about 0.01% - 0.02% and the Democrats want to impose a tax of 0.25%, which would increase transaction costs by an order of magnitude. Let me illustrate how this will impact people. The average managed mutual fund has an annual turnover of around 85%, meaning a average holding period of just over 1 year for their average stock. If their cost of transactions goes from 0.02% to 0.27% (the normal cost plus the tax), the total cost to that 85% turnover fund will go from 0.017% of assets to 0.2295%. Let's say you have $100,000 invested in that fund or in a variety of funds that have an average turnover of 85%. This transaction tax will increase your personal costs from $17 per year to $229.50 per year (plus as an asset tax and not an income tax, it will be disproportionately be shouldered by older taxpayers, even if they are already on a fixed income). Now let's say you have your money in a hedge fund. Many hedge funds, both quant and non-quant are trading oriented with high turnover, which can easily be in the 10,000% range (average holding period of just a couple days). So under the current system, transactions cost you 2% of your assets every year, a high number but one that can easily be overcome with good performance. With a 0.25% tax added to it, that same fund with 10,000% turnover will have a total transaction cost of 27% of assets, an almost insurmountable amount, especially on a regular basis. Just to put it in numbers, if you have $100,000 invested in that hedge fund, your personal transaction costs are $2,000 per year but will balloon to $27,000 per year with a 0.25% transaction tax. Needless to say, most quant funds and many hedge funds will no longer be able to operate in such a system. Volume in the markets will collapse (which will also cause receipts from this proposed tax to also collapse) and the market will become far less efficient. But don't take my word for it, take Burton Malkiel's:

Moreover, "Wall Street" would not foot the bill for the presumed $150 billion tax. In fact, the tax would simply be added to the cost of doing business, burdening all investors, including 401(k) plans, IRAs and mutual funds.

Some argue that high-frequency traders, who reportedly execute 70% of the equity market trades, would pick up the lion's share of the bill. But high-frequency traders are not villains—indeed, they play an important role in improving market efficiency.

Often mischaracterized as speculators, high-frequency traders scour markets for minor mispricings and arbitrage trading opportunities. They buy and sell stocks in an instant, hoping to earn pennies on a trade. Far from destabilizing or creating volatility in the market, their actions significantly increase trading volume, reduce spreads, promote price-discovery, and ultimately reduce transactions costs for long-term investors. Such trades might not be doing God's work, but they are socially useful.

Transactions costs have declined significantly over the past 10 years, thanks to the many structural changes in equity markets, including trading in decimals instead of eighths, the proliferation of scores of trading venues that function as exchanges, and an explosion of high-frequency trading. Vanguard has estimated that total transactions costs on an average trade have fallen by more than 50%, resulting in approximately $1 billion of annual savings to its investors. When magnified across the whole investment industry, investors have probably saved tens of billions of dollars in transactions costs.

Transactions taxes would make most current high-frequency trades unprofitable since they depend on the thinnest of profit margins. Trading volume would collapse, and there would be a dramatic shortfall in the tax dollars actually collected by the government. Market liquidity would decline, bid-offer spreads would widen, and all investors would pay significantly higher costs on their trades.