They're calling the wrong tax the "Robin Hood tax"

A report on the web suggests that Occupy Wall Street protestors may coalesce on a specific policy demand: the enactment of the so-called "Robin Hood tax" on financial transactions.

Although I have considerable sympathy for what I deem to be the OWS political economy critique of U.S. policy and institutions, I fear that they are being misled by labels into supporting the wrong tax. It's understandable. After all, how could they resist something that proponents call the "Robin Hood tax" and that would be collected from banks and other such financial institutions, given what the OWS protestors (and we) know about the U.S. financial sector and its grip on the U.S. economy and government, as well as that sector's responsibility for the last few years' disasters and the evident possibility that they will soon be doing it to us again?

The problem is, the wrong instrument has been labeled the "Robin Hood tax," apparently because some enterprising policy entrepeneurs, undoubtedly acting in good faith, took the initiative thus to label what those of us in the biz call the "financial transactions tax" or FTT.

The so-called Robin Hood tax - which I will now switch to calling the FTT - would be levied at a very low rate (say. 0.05%) on a wide range of financial asset transactions - for example, the sale of stocks, bonds, commodities, unit trusts, mutual funds, and derivatives such as futures and options. Thus, if you buy Microsoft stock for $10,000, the tax at 0.05% would be $5. Despite the low rate, enough financial assets in face value are sold that it could add up to a lot of money. For the thing to work, it obviously would have to address the problem of people, say, using swap transactions to replicate the economics of a debt-financed purchase of stock without actually doing the literal sale. That's a big problem, but let's put it to one side for present purposes.

Presumably your broker will actually remit the $5 sale proceeds to the tax authorities. I would guess that he'd list it as a separate charge that you had to pay, and would simply add it on to the other fees he was charging you. In principle, this could exert a mite of downward pressure on broker fees, raising the economic incidence question of who bears the tax, along with the possibility that, with sales being costlier, there'll be a small bit of exit from the broker industry. But it might be a good first approximation to say that you are likely to bear the tax, whether the broker separately states it or simply charges you $5 more than he would have otherwise.

Now let's consider Goldman Sachs, which presumably would be remitting a whole lot of fees to the government from the deals it does. (Leaving aside the fact that they would no doubt be at the forefront of figuring out, at least for their large customers, how to structure deals so as to avoid the tax.) Is this a tax "on" Goldman Sachs - or more specifically, on the firm's owners and highly compensated employees? I am a bit skeptical, as a matter of economic incidence. Come to think of it, if they do figure out how big players can avoid the tax they will be well-compensated for that, but even in other cases I suspect the incidence issue might play out a bit like the retail sales tax that the guy in the candy store collects from you and then remits to the local authorities.

The broader academic debate about the FTT - on which I will be presenting a short piece at a conference in Amsterdam in early December - emphasizes the efficiency question. Will the FTT have desirable economic effects? With perfectly functioning financial markets, the answer would obviously be no. Why burden trades that conventional economic reasoning suggests make the transactors better off while hurting no one else. But I would agree that we have reason to be very unhappy about a lot of what goes on in financial markets, so the FTT has a fighting chance.

What among the things that might be wrong with financial markets might the FTT address? The main argument is about volatility, which some types of trading may make worse. This is basically an externalities argument. By running computer programs that, say, go SELL-SELL-SELL as soon as the price of Zircon stock falls below $X, one can prompt runaway market panics. But the problem is that the FTT is not well-designed to address a specific externality. Trading can also reduce volatility. And if I want to buy or sell a given stock then it's good for me that someone else is actually willing to do so at a given price. FTT studies suggest that the tax might well make volatility worse rather than better. More generally, a well-designed instrument would have to target the types of trading that were worth discouraging.

A second point is sometimes called "internalities." Suppose people trade too much from the standpoint of their own welfare because they over-rate their ability to out-smart or correctly time the market. Once again, we're only in a subcategory of the overall trading that would be subject to the FTT. I have doubts about how strongly this line of reasoning can support the so-called Robin Hood tax, and it is certainly light years from the rationale and assumed incidence.

Now here's what I not only prefer to the FTT but think is far more entitled to the label of "Robin Hood tax" - a financial activities tax or FAT, such as that recently proposed by the staff of the International Monetary Fund.

The FAT would be a tax on extra-normal returns earned by financial institutions, with the potentially taxable returns including high-end compensation paid out to the big hitters. The FAT has two main rationales, other than the fact that the financial industry may generally be both over-large from a normative standpoint and widely under-taxed under VATs and income taxes.

The first rationale is that extra-normal returns may be rents, or opportunities that they have, in effect, to get free money not available to others. Taxing rents is efficient because it won't discourage activity that still has an extra-normal after-tax return. Plus, a tax on rents is borne by the party that is earning the rents.

The second rationale is that observed extra-normal returns in the financial sector are in a sense fake. They represent risky bets, the expected return from which is merely normal, but where the bettors earn an above-market rate in most states of the world, subject to downside "tail risk" if things go badly wrong. We don't want the financial sector making these bets due to their "heads I win, tails you lose" character, in which first they get extra-normal returns, then we have to bail them out so as to mitigate the degree of global macroeconomic collapse.

Once again, we would expect the financial sector to bear the incidence of this tax, because they'd be pushed back in the direction of a merely normal return by the mechanism of in effect taxing them for the suspected transfer of tail risk to the rest of us.

The FAT truly is a Robin Hood tax that would address the problems with the financial sector and likely be borne by the bankers themselves. Why tax Goldman Sachs' customers under the FTT, with no clear efficiency gain, instead of taxing Goldman Sachs itself under the FAT (leaving aside the most recent quarter, in which they reported losses) and addressing the costs that it may be imposing on the rest of us?