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A Progressive Tax With Beneficial Effects

A Small Levy on Financial Transactions Would Steer Clear of Struggling Americans, Raise Meaningful Revenue, and Possibly Retire An Abusive Wall Street Industry

Takeaways

A small tax on financial transactions, such as a one-tenth of 1 percent levy on the purchase of stocks and bonds, would likely end the viability of high-frequency trading while raising consequential sums for the U.S. Treasury. Opponents of this proposal have claimed it would hinder the ability of middle-class families to save for retirement. In contrast, we conclude that the costs of a modest financial transaction tax (FTT) would be little to nothing for middle-income families and would be easily manageable for average families in top income bracket.

  • Only about half of U.S. families would likely experience any costs at all from a financial transaction tax. Because only about half the families in the United States have retirement accounts and very few of the families lacking retirement accounts likely own non-retirement securities, about half the families in the country would likely experience no costs at all from a financial transaction tax.
  • An FTT could actually save families money. Incentives posed by an FTT could result in families saving more money than their costs from the tax. That is primarily because existing overhead and transaction costs that mutual fund investors already pay dwarf their potential costs from the FTT. An FTT would encourage mutual funds to reduce the rate with which they buy and sell stocks. This would not only reduce costs that consumers experience from an FTT, but would yield additional savings in reduced mutual fund overhead and non-FTT transaction costs.
  • An FTT would be progressive. An average family in the lowest fifth of family incomes (median 2016 earnings of $15,100 a year) that has a retirement account would experience estimated costs of about $4 a year from a one-tenth of 1 percent FTT, according to Public Citizen’s estimate. An average middle-income family (median income: $52,700) that has a retirement account would experience about $13 in annual costs. Families in the top 10 percent of incomes (median income: $260,200) would experience about $155 in average costs relating to their retirement accounts, while many would owe additional taxes for trading stocks outside of retirement accounts. [Figure on next page shows the prospective effects of the tax on retirement accounts by income group.] Costs based on estimates issued by the Investment Company Institute, discussed later in this report, would be somewhat higher, but still modest, and similarly progressive in relation to income groups.
Chart showing financial transaction tax costs will be low.

Introduction

Unlike on purchases of most goods, there is no tax on purchases of stocks, bonds or other securities.[1] Over the years, policy advocates and public officials have put forth various proposals to institute a small levy on these transactions.[2]

Such proposals might appeal to those who wish to create a more progressive tax system, raise money for public investments, reduce the federal deficit, or deter high-frequency, computer algorithmic trading.

A financial transaction tax,[3] or FTT, would inherently be targeted toward people of greater means. That is because it would be assessed only on those who have investments in the stock market, and roughly in proportion to the size of investors’ assets. Stock ownership is closely correlated with wealth.

Such a tax has the potential to raise meaningful amounts of revenue. The Wall Street Tax Act introduced by Sen. Brian Schatz (D-Hawaii) and Rep. Peter DeFazio (D-Ore.)[4] – which would tax the sale of most stocks, bonds and derivatives at one-tenth of 1 percent – is similar to a proposal that the congressional Joint Committee on Taxation last year estimated would raise $777 billion over a decade.[5]

An FTT also would discourage high-frequency trading. This is a strategy, memorialized in Michael Lewis’s best-selling book “Flash Boys,” that involves buying and selling securities in intervals of milliseconds based on computer algorithms. High-frequency trading is estimated to account for more than half of stock trades.[6]

High-frequency trading may pose a risk to ordinary investors because the phenomenon of computers acting on other computers’ signals could trigger a runaway chain reaction, causing a stock market meltdown. High-frequency traders have been blamed in part for the 2010 “flash crash,” in which the Dow Jones Industrial Average lost about 10 percent of its value in 10 minutes for no apparent reason.[7]

Setting aside the potential of high-frequency traders to infuse risk into the stock market, the strategies they employ are simply unfair. High-frequency traders enjoy advantages that enable them to receive information and complete orders a split-second sooner than others. This allows them to profit at the expense of other traders.

A financial transaction tax would presumably suffocate the high-frequency trading industry because the tax would largely correlate with trading volume, and high volume is the oxygen of high-frequency trading.

Critics of an FTT, such as mutual fund industry representative Investment Company Institute, have predicted that the tax would hurt all investors “especially middle-income Americans workers saving for retirement.”[8]

We find this claim to be unfounded.

By our calculations, an average middle-income family that has a retirement account would experience only about $13 a year in costs from the proposed FTT. (Most families would not pay the tax directly; instead, mutual funds would pay it, and then presumably pass their costs on to their customers.) If we apply the Investment Company Institute’s estimates, we conclude that the same average middle-income family would experience about $13 to $35 in annual costs from the tax, depending on the family’s mix of investments.

Meanwhile, any costs from the tax would apply only to families that have retirement accounts or other securities. About half of U.S. families do not have retirement accounts, and available data indicate that families without retirement accounts are unlikely to own non-retirement securities. Therefore, about half of U.S. families likely would not experience any costs at all from an FTT.

The effects of the tax would be somewhat different for upper-income Americans, although hardly onerous. About 90 percent of families in the top 10 percent of incomes (median 2016 earnings: $260,200) have retirement accounts. They would experience an average of about $155 a year in costs relating to their retirement accounts from an FTT by our estimate, and between $202 and $564 if the estimates published by the Investment Company Institute are applied. Many in this income strata – unlike those in other income bands – own stocks and other securities outside of retirement accounts and would owe taxes for trading in those assets, as well.

Notably, these estimates do not take into account the near certainty that incentives created by the financial transaction tax would depress trading activity. This would result in actual FTT costs for investors that are lower than those estimated based on current trading volumes. A reduction in trading motivated by the implementation of an FTT would have the salutary effect of reducing mutual fund overhead costs and transaction costs that hinder investors’ returns.

Taking these factors into account, it is quite possible that ordinary families would experience net savings after an FTT begins because their savings from reduced trading activity by their funds would exceed the costs that families experience from an FTT.

Average Annual Retirement Account Costs Resulting From the FTT for a Middle Income Family Would Range From $13 to $35

Opponents of a modest financial transaction tax have said that it would hurt ordinary families. In this report, we take a close look at the costs that families could expect to experience from a 0.1 percent financial transaction tax. By two methodologies, including one that applies industry estimates, we reach a conclusion that costs to most families would somewhere between trivial and nonexistent.

As stated in the introduction, our estimates do not take into account the near certainty that incentives posed by the tax would dampen stock trading volume, which would result in lower financial transaction taxes than projected in this report, and would yield ancillary savings for consumers.

In both of the methodologies, we estimated the costs to families’ retirement accounts from a financial transaction tax according to families’ income levels. We focused on retirement accounts because relatively few American families own stocks or other securities that are not held in retirement accounts.

Public Citizen Methodology

We estimated the costs to families from the financial transaction tax by taking the median retirement account size by family income level, as reported by the Federal Reserve, and assuming that families contribute 9.9 percent of their income to their retirement accounts annually. This is the median rate of contribution to retirement accounts, as reported by mutual fund company Vanguard in its most recent annual report on retirement savings. This contribution rate takes into account both employee and employer-financed portions.[9]

We assumed that families would invest in mutual funds with 32 percent annual turnover, the industry average. Mutual fund turnover – which regards the frequency with which funds buy and sell the securities that make up their portfolios – stands to be the primary cause of costs to retirement accounts from an FTT.

We assumed that the FTT would result in costs to family retirement accounts in two ways, each of which concern costs that would be paid by mutual funds and passed on to consumers:

  1. Costs relating to mutual funds’ purchase and sale of securities

When a mutual fund buys shares of stocks or bonds to change its portfolio or it purchases securities by reinvesting dividends, those purchases would be taxed. We assume that those taxes would be passed on to consumers.

  1. Costs relating to consumers’ purchases and sales of mutual fund securities

When consumers purchase shares of a mutual fund security, they would not be taxed on the purchase itself under Wall Street Tax Act because new issues of a security are excluded from the tax, and a mutual fund offering would count as a new issue. But consumers’ purchases of a mutual fund security could require the mutual fund to purchase the underlying stocks that make up the mutual fund offering. For instance, if the mutual fund’s portfolio consisted of all the stocks in the S&P 500, the mutual fund would need to own those underlying stocks to populate its fund offering. To the extent that the mutual fund experiences more incoming investment than withdrawals, the fund would need to purchase additional stocks on the open market. Those purchases would be taxed.

We are not able to estimate how frequently a fund would need to purchase new shares, as opposed to simply filling orders with the shares freed up by other customers’ withdrawals. In this report, to offer a broad interpretation of potential costs to consumers, we assume that the fund would need to purchase new shares each time consumers contribute to their retirement accounts. This assumption almost certainly exaggerates the frequency with which funds would need to purchase shares.

Eventually, families cease to make contributions to their retirement accounts and begin making withdrawals. When families sell shares of mutual funds back to mutual fund management companies, those sales would count as purchases for the mutual fund, and would be taxed under the proposed FTT. Again, we assume that mutual fund companies would pass those costs on to their customers.

For simplicity, calculations for this report assume that families would withdraw funds at the same rate that they previously contributed funds. Therefore, we assume that families that are withdrawing funds from their retirement account would experience the same annual costs from the FTT as those making contributions at the corresponding income levels.

In reality, a family’s annual rate of withdrawal would likely differ from its annual rate of contributing. But even if our methodology has significantly underestimated the rate of withdrawal, the effect on our overall conclusion on costs resulting from the FTT would not likely be significant for most families. That is because most of the costs from an FTT would result from mutual funds buying and selling their portfolio securities, rather than from consumers exchanging mutual fund shares.

In this report, we estimate that average families below the 80th income percentile that are withdrawing funds from their retirement account would experience between about $1.50 and $9 in average annual costs from a 0.1 percent FTT associated with their sales of mutual fund shares. Thus, even if families’ actual rates of withdrawal proved to be three-times greater than our estimate, they would only experience only about $27 a year in costs for these withdrawals at the high end. By our estimate, families in the top 10 percent of incomes would experience about $25 a year in average annual costs relating to purchases and sales. Thus, they would experience about $75 a year in sales-related costs if their actual rate of withdrawals were three-times greater than our methodology assumes.

Combining factors 1 and 2, described above, households with retirement accounts that have incomes in the lowest 20 percent (median 2016 income: $15,100) would experience an average of about $4 a year in annual costs from the FTT. But only about one-tenth of these households have a retirement account, and even fewer own non-retirement securities. Therefore, nearly 90 percent of households with incomes in the lowest 20 percent would likely experience zero costs due to a financial transaction tax.

Only about half the families in the middle-income band (median 2016 income: $52,700) have a retirement account. They would pay an average of about $13 per year in financial transaction taxes relating to their retirement account by our methodology. The 47 percent of families in this income band that do not have a retirement account would pay zero, unless they hold stocks or other securities in non-retirement accounts. Only a small percentage of middle-income families own non-retirement securities, and those that do are likely among those that also have retirement accounts.

More than 90 percent of families in the top 10 percent of income (median 2016 income: $260,200) have a retirement account. They would pay an average of about $155 annually in financial transaction taxes relating to their retirement account, according to our methodology. A significant percentage of families in this income band also would owe taxes for trading in other securities.

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