Beware the transaction tax proposal

Wealthy investors and their financial advisers seem to be in the sights of state governments seeking new revenue or more-efficient ways of expanding current revenue streams.

And the federal government might not be finished hunting for more revenue from investors and financial institutions.

The federal government is already extracting additional revenue from wealthy taxpayers through the 3.8% tax applied to the net investment income of couples earning more than $250,000 annually and singles earning more than $200,000 that went into effect Jan 1. This tax was imposed to help pay for the health care reform law.

The financial services industry seems to have beaten off recent efforts to expand state sales taxes to investment advisory services in Minnesota and Ohio, as reported in the last issue of InvestmentNews, but the industry must remain on guard. Such proposals could come back in modified form and also could pop up in other states.

Meanwhile, some Democrats in Congress have long desired to impose a tax on financial transactions, and their proposals may find new life if some members of the European Union proceed with plans to impose such a tax.

In February, Rep. Peter DeFazio, D-Ore., 19 members of the House of Representatives, and Sen. Tom Harkin, D-Iowa, and Sen. Sheldon Whitehouse, D-R.I., proposed a 0.03% tax on stock, bond and derivatives trades. According to the Joint Committee on Taxation, such a tax would raise $352 billion over 10 years. Proponents argue that such a tax could help reduce the budget deficit or pay for needed public spending without unduly burdening individual in-vestors, while hitting high-frequency trading and reducing market volatility.

By the committee’s estimate, the tax — 3 cents on every $100 of transactions — would cost someone with a $60,000 401(k) account just $18 in additional tax, which would be offset by a credit for taxes paid on such accounts. Of course, once imposed, it might not stay at 0.03% for long.

That there are 19 co-sponsors in the House suggests that opposition to a financial transaction tax might be weakening.

Although the Obama administration officially has no interest in such a tax — both Lawrence Summers and Timothy Geithner opposed it when they were Secretary of the Treasury — current Treasury Secretary Jack Lew has been much more open to the idea in private, according to Mr. Harkin.

However, the success or failure of the proposed European tax, or pressure from Germany and France, could change the Obama administration’s stance.

Last August, France enacted a limited financial transactions tax. Eleven members of the European Union have agreed to impose a financial transaction tax next year at a rate of 0.1% on trades of stocks and bonds, and 0.01% on derivatives transactions.

However, Great Britain, which has Europe’s largest financial sector, and Sweden, which tried such a tax in 1984 and abandoned it in 1991 as a failure, as well as a few smaller countries, actively oppose the European tax and won’t join in imposing it.

A number of academic studies have suggested that financial transaction taxes can have unanticipated results. For example, rather than reducing volatility, one of the alleged purposes of such a tax, studies have found that they increase transaction costs. And higher transactions costs, in turn, have been linked to more, not less, volatility.

IMF studies

A 2011 study published by the International Monetary Fund argued that a securities transaction tax would reduce trading volume and could decrease liquidity. Another IMF paper found that such a tax would impede price discovery.

One reason might be that even small transaction costs would make continuous re-balancing of portfolios very expensive, so valuable information could be held back from being incorporated into securities prices.

All these effects would be negative for investors and wouldn’t be offset by the credit for tax-exempt transactions.

The extension of sales taxes at the state level to advisers or the imposition of a financial transaction tax at the federal level would negatively affect the financial services industry, and those seeking to save and invest for retirement.

Although it is unlikely that a federal transaction tax would get through the Republican-controlled House, that could change rapidly next year if the Democrats win control.

Therefore, investment advisers and the relevant financial industry associations must be prepared to resist the imposition of such taxes and must let their opposition be known now.