April 9, 2019

The 2020 Campaign and Taxes Part 2: Taxing Trading Transactions

2020 Campaign and Taxes

Taxes are frequently only thought of as a way for the government to raise revenue to pay for what it needs or wants. This line of thinking is evident in the tax plans discussed in Part 1 of our series on the 2020 presidential candidates’ tax plans. In that article we discussed tax proposals from Rep. Alexandria Ocasio-Cortez (D-NY) (although too young to be a candidate) and Sen. Elizabeth Warren (D-MA) that were specifically designed to raise revenue for their policy initiatives and programs.

But taxes can also be used to affect or implement social or economic policies directly. They can be, and frequently are, designed to encourage or discourage types of behaviors and activities. For example the charitable contribution deduction is designed to encourage charitable giving, while the provision of the Code that denies many deductions for those who trade in controlled substances, for example marijuana businesses, is clearly designed to discourage people from operating these businesses. It is an open ended question as to whether these taxes are effective at changing behaviors, but that has not stopped Congress in the past and it has not discouraged presidential candidates either.

This brings us to the next set of proposals. As with our first installment, one proposal is from a 2020 presidential candidate Sen. Bernie Sanders (I-ME), while the other is from a member of Congress, Sen. Brian Schatz (D-HI), who is not running for President. In this case, however, both policy proposals are very similar and they are both designed to affect a narrow band of activity -- reigning in computerized high-frequency trading (HFT). Sen. Sanders raised the issue in his 2016 presidential campaign and it is again part of his 2020 campaign, but Sen. Schatz introduced the most recent legislation.

High-Frequency Trading

Before we discuss the details of either proposal, it is important to have a basic understanding of what HFT is and the perceived harms it causes. This context is an important part of understanding the proposals themselves.

HFT is the automated trading of stock, bonds, currencies, or other items that are tradeable on a market, generally performed by large investment banks, hedge funds, and specialized HFT firms. These entities use high-speed networks and proprietary algorithms to execute millions of trades per day. It is volume that is the key; each trade may net a profit of a penny or two per share but with enough volume, those pennies add up. For this to work, there has to be enough volatility (price changes) in the market for there to be opportunities for such a profit. For example if a stock stays at the exact same price for a day, it would not be of interest to someone engaged in HFT, as there is no opportunity to profit off of the fluctuations in its price. But if a stock were to change in value frequently, then it could be an HFT target, and it could be traded thousands—if not millions—of times per day.

A computer can execute over 40 trades in the time it takes a person to blink an eye. If there is an error in the HFT programming or if there is a rush on the market due to an event or other trading activity, then HFT presents an opportunity for the computers to create wild fluctuations in the markets before their human operators have time to stop them. It is these “flash crashes” and the subsequent blame on HFT systems that brought the issue to the attention of politicians. (A flash crash is a rapid drop in the market that can occur in minutes.) The primary contention of both Senators is that HFT brings unnecessary risk to the markets, and that risk could harm the entire economy. In a September 2010 flash crash, the Dow Jones Industrial Average lost 600 points in less than 30 minutes; and while the Dow quickly recovered, it was a striking example of how fast the markets can fall. This flash crash was at least partially blamed on HFT. With this background in mind, it is easier to understand the proposals from the two Senators.

Sen. Schatz’s Proposal

The bill introduced by Sen. Schatz contains substantially more detail than the campaign position of Sen. Sanders. If it passes, the bill would subject stocks, bonds, and derivatives to a .1 % trading tax. The tax would be imposed on the fair market value (FMV) of stocks or bonds at the time of the transaction, or the amount paid for a derivative. The tax would be imposed on any stock or bond traded on a U.S. market, or where the buyer or seller is a U.S. person, i.e., a U.S. citizen or resident alien or a controlled foreign corporation. If enacted the tax, would be imposed upon the buyer unless it is not a U.S. person, in which case it will be imposed upon the seller.

There are some important exceptions. First, the tax would not apply to initial public offerings (IPOs). It also would not apply to stock options granted to employees and derivatives that require the delivery of tangible or real property at the time they are exercised. Additionally, short-term bonds, those with a maturity of 100 days or less, are exempt.

By taxing trading transaction of nearly all marketable stocks and bonds, it is easier to understand how it could discourage HFT transactions. At the .1 % tax rate, a stock trading at $10 would generate $.01 (a penny) of tax. And given that many HFT programs are designed to make $.01 per share, the tax virtually eliminates the benefit, and correspondingly reduces the volume, of these small margin trades. And Sen. Schatz believes that reducing this volume would reduce risk in the market.  He is on record as saying that roughly half of the 8 billion daily trades are HFTs.  As a result, he estimates that the tax could raise $770 billion dollars over a 10-year period; but the more effective this tax is, the less revenue it would generate. It is also not clear who would bear the ultimate cost of this tax. As noted previously, large banks, specialized HFT firms, and hedge funds are the primary participants in the HFT market. But they are not the only participants in the financial markets. Pension funds and retirement accounts also invest heavily in stocks and bonds, and it could be politically unpopular if the tax were cast as a tax on retirement plans. However, some studies have shown that as much as 84% of all stock in the U.S. is held by the wealthiest 10% of the population, so it may be that the burden on individual retirees could be very small.

Sen. Sander’s ‘Tax on Wall Street’

Senator Sanders, known for his populist rhetoric, generally refers to his HFT proposal as a tax on Wall Street. Under Sen. Sanders’ plan, there would be 3 different tax rates: a 0.5% rate on stock trades, a 0.1% rate on bond trades and 0.005% rate on derivative trades. The higher rate on stock trades could act as a stronger deterrent to HFT activity, as it would raise the threshold for HFT transactions to make a profit. As a result, it could potentially raise less revenue than the bill introduced by Sen. Schatz. Other than the rates, details about the Sanders’s plan are scarce, as his current campaign has devoted little time to discussing the transaction tax. Instead, he has placed the focus on what the revenue would be used for. Under Sen. Sanders’s plan, the revenue would be used to fund a program for college tuition assistance. This program, along with other spending plans discussed by the candidate, will be discussed in a future installment of this series.

Trading Transaction Takeaways

For now the key takeaway from these tax plans is uncertainty. Financial transaction taxes have not been implemented on a large scale basis in recent memory.  In 2013, The Guardian reported that:

“Eleven countries won the EU's backing for a financial transaction tax (FTT), with Germany, France, Italy and Spain adding their names to Eurozone neighbours Austria, Portugal, Belgium, Estonia, Greece, Slovakia and Slovenia. The UK, which already imposes a tax on share trades, could benefit from a shift in banking business if Germany and France tax foreign exchange or derivatives trading in Frankfurt and Paris.” 

By December of last year, however, Germany and France were still working on a joint proposal modeled on a system in place in France that taxes shares of domestic companies with market capitalization over 1 billion Euros.

Would such an HFT tax bring U.S. markets to a stand-still? Would it make it more difficult for businesses to raise capital? Would it function mostly as a tax on wealthy individuals or hurt retirees? If the plan progresses, we would expect to see more detailed analyses of its projected economic effects on individuals and businesses. And if that happens, we will strive to keep you up-to-date on these projections. In the meantime, for more information on these proposals and other tax related issues, please contact your local CBIZ tax professional.

2019 Business Tax Planning Supplement

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