Time for a tax on stock trading?
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From the savvy, timed-out baby who keeps a smart phone with an E• Trade app in his crib to the pervasive practitioners of securities swapping, sometimes it seems like everyone's a trader these days. Except maybe for somnolent 401(k) investors who seldom give their meager portfolios a second thought.
So why not levy a tax on trading to curb these speculators and help reduce the burgeoning federal budget deficit to boot?
The United Kingdom, Taiwan and other countries already tax securities trading. Adopting a tax similar to the 0.25 percent levy that the United Kingdom imposes on stock trades would raise more than $40 billion annually, according to a paper issued this month by the Center for Economic and Policy Research.
Co-director Dean Baker argued taxing the trading of stocks, options and credit default swaps would make it a less profitable pursuit without hurting the economy. The proposal also has a certain populist appeal.
"The tax will be borne almost entirely by the financial sector, not by ordinary investors," Mr. Baker wrote.
The "buy-and-hold" crowd took it on the chin when the stock market tumbled in late 2008. The ensuing trauma sparked the phrase "the Lost Decade," referring to the fact that investors who held stocks over the 10-year period broke even. Some went even so far as to declare buy-and-hold dead. But a Boston money manager doesn't believe that's the case.
"It's certainly not dead, but it's been overshadowed by the more hyperactive traders in the market," said Duncan W. Richardson, chief equity investment officer for Eaton Vance.
Pre-eminent among them are high frequency traders, sophisticated investors whose strategy is based on making high-volume, high-speed trades that capitalize on small, temporary price discrepancies divulged by their high-powered computers. Their trades are triggered by such events as a market index hitting a prescribed level, the divergence of two stocks that generally move in tandem or different markets putting different prices on the same security.
Many blame high frequency traders for the May 6 flash crash, when the Dow Jones Industrials fell 1,000 points in minutes. Others defend high-frequency traders, saying they provide much needed liquidity to the market by making it easier for large institutional investors such as mutual funds and pension funds to move in and out of the market without disturbing prices.
Retail investors who think they can outsmart the market aren't as easy to defend. They lack the knowledge and discipline of professional investors and, even if they guess right, have higher trading costs than their professional counterparts, said University of Pittsburgh finance professor Jay Sukits.
"You're always fighting against the institutions, and they always have the upper hand," he said.
A 2006 study found that the more actively individual investors trade, the less they earn. Their biggest problem is overconfidence, according to co-authors Brad M. Barber of the University of California-Davis and Terrance Odean of the University of California-Berkeley. They said investors overestimated their knowledge and abilities.
Trading firms target their overconfidence, whether it's E• Trade's cuddly baby who takes control of market volatility "wolf style" or the female jogger urged on by a voice that says: "Depend on yourself, the one person you should trust to take charge of your financial future."
Reality is usually strikingly different. Most individual investors tend to sell after the worst is already over and buy when it's too late.
"They tend to manage their portfolios from a rear view window perspective," Dr. Barber said.
He believes that Wall Street's recent ills should curb hypertrading individuals, who tend to be more active in bull markets. But what about the algorithm-armed high-frequency traders who sail in all kinds of markets?
Penn State University's John Liechty, who has helped Morgan Stanley and Goldman Sachs with statistical-based trading strategies, thinks some kind of trading tax might be reasonable. While liquidity provided by high-frequency trading is a significant benefit, "It's got to be monitored and controlled," he said.
One problem with such a tax is that it affects all traders, said Daniel Henderson, of CooksonPeirce, a Downtown investment firm.
"I think that that would probably never fly," he said. "All you're doing is passing that cost along to every end user."
Mr. Richardson suggested it might be better to revise tax rates to encourage long-term investing and discourage trading. Investors currently pay 15 percent on gains from investments held for a year or longer vs. up to 35 percent for short-term capital gains.
While the November elections created a more pro-business environment in Washington, Mr. Baker wrote, "It is striking that financial speculation taxes have received almost no attention."
He estimated a more aggressive tax than the United Kingdom's would raise $150 billion a year, enough to put a sizable dent in the federal deficit.
Whether the horse traders on Capitol Hill take him up on the proposal is open to speculation.
First Published January 30, 2011 12:00 am