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January 20, 2010

Why Dr. Tobin's Big Idea Should Remain Buried

There are few things sadder than the big idea born too early. We all know the story: A flash of brilliance is followed by years of public ridicule and frustration, the unrecognized genius eventually dying alone and penniless. Years later, the big idea is dusted off and re-examined, but this time, it's embraced, and we get the satisfaction of seeing the inventor's name belatedly join the pantheon of genius to which it rightfully belonged.

And so I had a warm feeling on behalf of the late Dr. James Tobin, when I read Paul Krugman's recent New York Times column announcing that the Tobin Tax was "an idea whose time has come." A "Tobin tax" is the en vogue name for a tax on financial transactions, named for Yale economist and Nobel laureate Tobin, who dreamed up the idea in 1971. After 31 years of advocacy, Dr. Tobin passed away in 2002 at the age of 84, having never experienced the pleasure of paying his own tax.

But now in 2010, eight years after being buried, it appears that Dr. Tobin's dream is being resurrected.  Not surprisingly, this required some help from the Lord--by which I mean Lord Adair Turner, of course, the chief of the FSA and the top financial regulator in Europe. Lord Turner strongly endorsed the tax last August, famously deriding traders as "socially useless," and saying the tax would be a "nice sensible revenue source for funding global public goods."

On Dec. 3, Dr. Tobin's idea took a big leap from the fringes, as Rep. Peter DeFazio, D-Ore., introduced the tax, subtly titled "The Let Wall Street Pay for the Restoration of Main Street Act of 2009." Unlike some of Mr. DeFazio's previous forays that were laughed out of Congress, this time he had lined up an impressive roster of 28 fellow legislators as co-sponsors. Sen. Tom Harkin, D-Iowa, introduced a similar bill into the Senate on Dec. 23, called the "Wall Street Fair Share Act," co-sponsored by three other U.S. senators.

So now Dr. Tobin's big idea has finally graduated from a dismissed intellectual theory into two very real-world proposals.  The two bills both tax stock trades at 0.25 percent (25 basis points in Wall Street parlance). In both bills, the tax is owed on any transaction that occurs on a "trading facility" located physically within the U.S., or anytime either the buyer or the seller is a U.S. person or entity. The tax is not based on the security being U.S.-based--an American who buys Toyota on the Tokyo would still owe 25 basis points to the U.S. government.

There are some differences between the two bills: Mr. DeFazio gives bonds a free pass, and gives futures and swaps a big break, taxing them at 0.02 percent (2 bps), while options are at the tax rate of the underlying security. Mr. Harkin's bill is harsher, taxing all securities including bonds at the rate of 0.25 percent, except for ones that expire or mature in less than one year, which get a rate of 0.02 percent.

So how would traders react?  Well, many politicians think traders wouldn't react at all.  As Speaker of the House Nancy Pelosi said, 0.25 percent is so small, the tax would have "minimal impact." 

But among those with some industry knowledge, even ardent supporters of the tax understand it would shut down market making and dramatically reduce trading activity.  In fact, for Professor Krugman this is a primary reason to enact the tax, as hordes of bright people would be incentivized to leave Wall Street and move into fields that he deems useful to society.

While Professor Krugman is excited at the prospect of Wall Streeters packing their bags, he thinks the average Joe would be unaffected, since the tax would be a "trivial expense for long-term investors."  But the numbers are ugly for all investors. A small investor who buys 500 shares of IBM using an online broker today pays about $8 in commissions. 

Thanks to all the socially useless short-term trading, IBM today has a penny-wide spread, meaning that the little guy's round-trip transaction costs including spreads are about $21.  Now add the tax bill of $164, plus increased commissions (since without market makers, retail rebates would go away), and finally add significantly increased spreads (again due to the lack of market making), and I estimate the round-trip cost of 500 shares of IBM would be approximately $300, more than 14 times what it costs today.

Another way to put the cost in perspective is to view it through the prism of Regulation NMS. As part of the National Market System reforms, exchange fees were capped at 0.3 cents per share in 2007. At 25 basis points, the Tobin Tax on IBM would be a whopping 33 cents per share, more than 110 times the cap the SEC put on the transaction.

But what academics would inevitably find frustrating is that while the "little guy" trading IBM will get slammed, professional traders may not actually end up packing those bags after all. While foreign investors would likely just avoid investing in the U.S. altogether, American investors wouldn't have an obvious way around the tax.

Therefore, one of the first order effects under either the House or Senate version would be a mad rush by American traders to the options exchanges. Under the Senate version, traders could get exposure to equities via options taxed at 2 bps instead of 25 bps. Under the House version, the tax on equity options is only paid on the options premium, not the notional value of the underlying stock. I'd expect that cash settlement of options on expiration would quickly become the norm, to avoid ending up with dreaded stock.

In the mad rush to avoid equities, index futures would immediately reclaim the ground they've lost in the past decade to ETFs, which would be decimated, and single-stock futures would return to traders' conversations after a long silence. If the tax passes, the first and most obvious trade is to go long Chicago and go short New York City.


Another unintended consequence would be damage to corporate governance.  Most professional investors would likely hold options and futures for cash settlement instead of being actual shareholders with voting rights, taking many proactive shareholders out of the voting picture. Other weird effects would follow.

Under both bills, retirement account trades are exempt. But the bills charge 25 bps to the exchange (not 12.5 bps to both buyer and seller), and they exempt the entire transaction if either side is a retirement account.  If this weren't corrected, retirement funds would be able to sell their tax-free flow to others for a large rebate--pension funds would quickly replace high-frequency traders as Wall Street's primary market makers and liquidity providers.

The deeper we dive into this proposal, the more inefficiencies, odd distortions and bizarre consequences bob to the surface. We start to get the feeling that Tobin's big idea simply isn't worth the mess, and should once again be buried. But before we feel sad about the good Dr. Tobin's return to obscurity, let's remember that he was a brilliant man known for far more than just his eponymous tax.

In 1966, the future Nobel Prize winner wrote: "We should be especially suspicious of interventions that seem both inefficient and inequitable, for example, rent controls in New York or Moscow or Mexico City, or price supports and irrigation subsidies benefiting affluent farmers." Amen to that, Dr. Tobin. May we be very suspicious of irrational government interventions in business. And may you and your tax plan rest in peace.


Dan Mathisson, the head of Advanced Execution Services (AES) at Credit Suisse, is a columnist for Traders Magazine. The opinions expressed are his own, and do not necessarily represent those of the Credit Suisse Group.

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