A reader posted an interesting comment arguing against certain types of tax reform and for a financial transctions tax, such as when someone buys stock or bonds.

As always I appreciate a thought-provoking comment, whether I agree or not. In this case, I disagree and think the issue is interesting enough to write a specific piece about, so here goes:

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Hi Lew,

While I appreciate any constructive thought about how to deal with our government's fiscal issues, I must disagree with your proposal on a securities tax and your prior analysis of other tax proposals.

Let me start with the other parts of your argument:

a) A flat tax does not increase tax "stress" on a population. A sales tax changes the allocation of stress somewhat, but does not increase it overall (unless it's done without eliminating the income tax).

b) I don't buy the argument that a national sales tax would substantially inhibit consumption or be bad for the economy. First, people will have more money in their pockets from the eliminated income tax. (If you earned $10/hour, would you spend $10 on something that cost you $9 when you were earning $9/hour? I think so.) Second, money has to go somewhere so if money is not spent on consumption, it will be saved and invested which leads to all the usual good things for the economy that investment causes as well as a much greater likelihood of people not being reliant on only government in their retirement years.

c) A flat tax or national sales tax would be FAR less complex than our current system, not to mention the enormous savings in compliance costs (especially the flat tax). According to the Tax Foundation (www.taxfoundation.org) "In 2002 individuals, businesses and non-profits will spend an estimated 5.8 billion hours complying with the federal income tax code (henceforth called “compliance costs”), with an estimated compliance cost of over $194 billion."

d) This is the scary one: We absolutely can not allow any national sales tax or VAT unless the income tax is eliminated at the same time. If we have both systems at the same time because then both taxes will just keep rising and government will keep expanding like a leech that just found the biggest vein on an animal.

Now to Social Security, personal accounts, etc:

It's pointless to try to separate the employer's part from the employee's part. It's the same money....it all could be the employee's if the government weren't taking it.

I don't think you can reasonably argue that contributions "without the employers'" part will be too small to matter. We're talking about something like a third of someone's total payroll tax (I hope). It's not insubstantial, and given that it's built up and compounded over a career, even less than this can turn into a big number. Also, if you want to argue that it is insubstantial, what could be any possible purpose to have ANY Social Security contribution since "return" in that system is probably 1/3 or 1/4 of what one would get long-term in a personal account. If I were a low income worker I'd be pretty irate at someone telling me that my savings is so small that I shouldn't bother, but at the same time saying I should just keep giving that money to the government because they can't live without it.

While it's true that the debate about personal accounts has a lot of political ideology running through it now, that's no reason to drop the debate. To pick an extreme example, slavery had political ideology but that didn't mean we shouldn't have tackled the issue. It is possible for one side simply to be right.

Your argument against personal accounts because people have bills to pay and have to eat daily is a red herring because that money is not available for those purposes anyway.

Also, I don't think that most people think the market is too risky for long-term investing. According to the Investment Company Institute (www.ici.org) at the end of 2004, 54 million US households owned mutual funds, or about 48% of total households, including 27% of households with income under $50,000. There's about another 6% of households which own stocks directly (and not mutual funds).

Here's a 2002 study of equity and mutual fund ownership:
http://www.ici.org/stats/res/rpt_02_equity_owners.pdf
And a 2004 study of mutual fund ownership:
http://www.ici.org/pdf/fm-v13n3.pdf

So, let's get to your securities transaction tax idea. It's absolutely wrong to say that there is "no cost or pain for anyone". Not only are there major costs to all the stock and mutual fund holders I just described to you, but you throw a wrench into the workings of the most important source of economic information and price discovery that we have.

Keep in mind that I was an options trader at the Chicago Board Options Exchange. I know what I'm talking about when I say you are absolutely wrong in assuming that a half a percent tax would not inhibit trading. Furthermore, you should do some homework on the value of having speculators in a marketplace. In fact, speculators and day traders are the main source of liquidity in most markets. They provide continunous pricing during times when other investors are not interested. This is especially true in derivative markets, but is also the analogue to the role of stock specialists. Most of the time speculators and day traders dampen volatility, not increase it.

In order to get the best price discovery and the most efficient allocation, one must not impede trading volumes and add friction to the process such that people will avoid trading. Here's a very interesting document which describes the importance of trading volumes and the likely damage done by a transaction tax:
http://econ.worldbank.org/files/23661_chap_11_taxation.pdf

One often-discussed example is Sweden which had a transaction tax but eliminated it because it A) caused trading to go offshore, B) caused people to find creative ways to trade to get around it, C) did not generate the expected revenue because of A and B.

As I mentioned, some have argued that a transaction tax could lower market volatility. Not only is that the opposite of what would happen (short and long term) but it's also a totally inappropriate role of government to decide what "volatile" is. Only bad things can happen when government starts taking an active interest in day-to-day behavior of the stock market.

Here's the best analysis I've found of the issue, by the Federal Reserve Bank of Kansas City.
http://www.kc.frb.org/publicat/econrev/pdf/2q94hakk.pdf

It looks at arguments for and against securities transaction taxes and then comes down firmly against them, including these very interesting comments: "Furthermore, if the tax is such a good idea, why are many countries reducing or eliminating their taxes? Sweden, Finland, and Taiwan have recently reduced or eliminated their taxes, while Australia, Japan, and the U.K. are considering reductions in their taxes (Froot and Campbell, p. 1). Finally, London is one of the biggest backers of a U.S. transaction tax. The London financial press believes that a U.S. tax would be good for business in London."

Finally, as you're obviously someone who cares about our government's finances, you should be careful about supporting any new tax without insisting on eliminating another tax at the same time.

Please keep reading and writing!

Ross