The impact of a financial transactions tax on futures trading volume | cepr blog


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The impact of a financial transactions tax on futures trading volume | cepr blog

  1. 1. ABOUT US PRESS CENTER PUBLICATIONS ISSUES ECONOMISTS RESEARCH TOOLS EVENTS Home Publications Blogs CEPR Blog The Impact of a Financial Transactions Tax onOp-Eds & Columns Futures Trading Volume SearchData Bytes The Impact of a Financial Transactions Tax on FuturesBlogs Trading VolumeGraphic EconomicsBriefings/Testimony Written by Dean BakerScorecard Series Thursday, 21 March 2013 15:21Books One of the reasons that many proponents give for supporting a budget economyFilms financial transactions tax (FTT) is that it will reduce trading volume in financial markets. education employment This can be considered good for two reasons. Haiti health careEn Español housing housing bubbleEm Português First it may reduce the likelihood of erratic fluctuations that have no basis in the inequality jobsOther Languages fundamentals like the flash crash in the spring of 2010. The existence of a huge amount of rapidly traded assets can create this sort of sudden divergence from fundamental labor driven prices. Reducing trading volume may reduce the probability of similar marketMultimedia minimum wage occurrences. OccupyWallSt paidEn Español The other reason that a reduction in trading volume is desirable is that it would reduce family leave poverty the amount of resources wasted in the financial sector. The labor and capital absorbed recession retirementEm Português Social Security taxes in trading are resources that could in principle be used productivity elsewhere in theOther Languages unemployment economy. If greater trading volume does not in some way result in the better allocation unions wages Wall of capital then we should be pleased to the extent that an FTT reduces trading volume in Street workers various markets. working class For this reason, a paper published by the CATO Institute last summer showing that a + All tags FTT would lead to a sharp decline in the trading of futures should not be seen as negative from the standpoint of proponents of FTTs.[1] Unfortunately, the paper did not accurately measure the decline in trading volume that would result from a tax, leading to an overstatement of the actual decline that would be implied with the tax rate and elasticities assumed in the paper. This mistake wrongly leads the paper to conclude that several major future markets would disappear even with a low tax rate. When a correct calculation is done, it can be shown that this is not true. The paper’s mistake is a simple one. Elasticities are usually calculated as point elasticities, which relate the change in quantity that would result from a small change in price. For most questions we ask, where we consider price changes that are relatively small (say under 20 percent) using a point elasticity will give us a reasonably good approximation of the change in quantity that would result from the change in price being considered. However for large changes of the type considered in this paper (all the changes in the price of transactions resulting from the FTT are far more than 100 percent of the current cost of transactions) it is necessary to be more careful in the calculation. The correct measure of elasticity to apply would be an arc elasticity. This relates the change in quantity over the average of the old and new quantity to the change in price over the average of the old and new price. Elasticity = (D Q/ ((Q1 +Q2)/2)) / (DP/ ((P1+P2)/2) Where Q1 is the pre-tax quantity, Q2 is the post-tax quantity, P1 is the pre-tax price of the transaction, and P2 is the post-tax price of the transaction. The change in quantity is D Q and the change in price is D P This formula generates considerably smaller decline in trading volume than the ones calculated in the Wang and Yau paper. This can be seen by taking the example of a 0.02 percent tax on S&P 500 futures highlighted in the paper. The paper assumes that the current transactions cost of a S&P future is $14.80. It calculates that the 0.02 percent tax on a future, with an average
  2. 2. future is $14.80. It calculates that the 0.02 percent tax on a future, with an averageprice of $283,981 in 2010 would increase transactions costs by $56.80, or 383.8 percentof the pre-tax transactions cost. The paper relies on prior work that estimates anelasticity of trading in the S&P 500 futures market -0.81. Applying the point estimatemethod to calculate the change in trading volume it multiples the percentage change inprice times elasticity, which gives:D Q = 383.8% * (-0.81) = -310.9%In other words, this completely eliminates the market since trading volume declines bymore than 100 percent.However, if we applied an arc elasticity then the percentage change in would be -69.3percent (see appendix for this calculation):[2] This is of course a very large drop intrading volume, but would still leave a market with annual trading of $670 billion, downfrom a pre-tax market volume of over $2 trillion.In fact, if the correct methodology was applied to the other futures contracts shown inTable 2 in the paper, it is unlikely that any markets would actually disappear as a resultof a 0.02 percent tax. (The paper doesn’t show current trading costs for other markets,so it is not possible to be certain this is the case.)With elasticities that are less than one, it is impossible for any price increase tocompletely eliminate the market. Even when elasticities are slightly above 1, it wouldtake an extraordinarily large increase in prices to completely eliminate a market.[3]This should not be surprising if we step back and consider the issue for a moment. If atax of 0.02 percent would eliminate the market this means that the value of trades inthis market is less than 0.02 percent of the price of futures contract being traded. Whilethis is likely true for many of the trades in the market, it is unlikely to be true for all ofthe trades.Futures contracts do serve an economic purpose and it is unlikely that the actors in themarket who are buying contracts for their actual purpose (e.g. farmers wantinginsurance on crop prices or airlines wanting insurance on jet fuel costs) would abandonthe market completely if the price of the contract were to rise by 0.02 percent of thenominal value of the contract. In fact, since many of these futures markets have existedfor many decades, when transactions costs were far higher than they would be noweven with a 0.02 percent transactions tax, it is not plausible that this tax wouldeliminate the market.The fact that trading volume would tumble as a result of the tax is likely consistent withhow most supporters of FTTs would view its impact. The FTT would eliminate a largeamount of short-term and speculative trading, while still allowing a large enough volumeof trading for the markets to serve their purpose. In this case, the tax on this singlefutures contract (which has one of the lowest trading volumes of the futures contractsshown in Table 2 of the paper) would still raise $135 million a year in revenue each yearand almost $2.0 billion in the 10-year budget window.The incidence of this tax falls overwhelmingly on the financial industry, even in this casewhere we have assumed that 100 percent of the tax is passed on to traders in the formof higher costs. Previously traders had been paying $114 million a year in transactionscosts on S&P 500 contracts, according to the estimates in the paper. After theimplementation of the tax they would be spending $168 million a year, including thetax. This means that the government would be collecting $133 million annually whiletraders were only seeing their costs rise by $54 million, as shown in Table 1.The situation would look even better from the standpoint of traders if we assume that amodest portion of the tax (e.g. 10 percent) was eventually passed on to the financialsector in the form of lower fees per transaction. This seems plausible since the sharpdrop in demand for services from the sector is likely to lead to some decline in thewages and prices in the sector. In this case the reduction in trading volume would beslightly less, with volume falling to $710 billion a year. The tax would then $142 milliona year, or more than $2.1 billion over the 10-year budget horizon. However in this case,because the fees charged by the intermediaries had fallen, the amount spent on tradingwould be just $161 million a year, just $47 million more than before the tax was putinto place. In this case, financial intermediaries would bare 64 percent of the incidenceof the tax ($91 billion/ $142 billion). Table 1
  3. 3. The Case of S&P 500 Futures Total Trading Industry Percent Taxes Trading Volume Fees Borne by Costs (millions of Industry (trillions of (millions of millions) dollars) dollars) dollars)Before tax 2.2 114.0 0.0 114.0 NAAfter-tax -- 100 0.7 34.8 133.0 167.8 59.6%percent pass throughAfter-tax 90-percent 0.7 23.0 141.7 164.7 64.2%pass throughSource: Authors calculations, see text.The trading that is eliminated can be viewed as a waste of resources. The resourcesreleased by the reduction in trading volume will then be available for use in productivesectors of the economy.It is worth noting that situation would look better from the standpoint of traders forassets where the demand is more elastic, since this means that the same percentagetax increase would result in a larger decline in trading volume. The estimate of elasticityfor S&P 500 contracts is lower than all the other estimated elasticities that appear in theWand and Yau paper, except for home heating oil. (The elasticity on future contracts forhome heating oil is estimated at -0.80, compared to 0.81 for S&P 500 future contracts.)This means that a larger portion of the tax would be borne by financial intermediariesfor these other contracts.ConclusionA modest financial transactions tax will lead to a sharp falloff in trading volume for manytypes of financial instruments. However it is unlikely to eliminate markets altogetherexcept in cases where the instrument provided very little value to the economy. Thedecline in trading volume is one of the goals of the tax both since it may reducevolatility in financial markets and reduce the amount of resources consumed by thesector, freeing them up for productive uses elsewhere in the economy. The greater theelasticity of demand in a market, the larger the portion of the tax that will be borne bythe financial sector rather than end users. In almost all cases, the financial sector islikely to bear the vast majority of the burden of the tax resulting in considerably lowerwages and profits in the sector.AppendixWorking with the numbers from the article, we have:%DP = $56.80/ (($71.60 +$14.80)/2) = $56.80/($86.40/2) = $56.80/ $43.20 =131.5%We then have to relate this 131.5 percent change in price to the change in quality usingthe elasticity estimate of -0.81. This means that the change in quantity will be -0.81 *131.5 percent or -106.5 percent of the average of the old and new quantities:DQ = -106% *((Q1 +Q2)/2) = -106%*(( Q1 +Q1 +DQ) /2), since Q2 = Q1 +DQ = -106% * ((2Q1/2) +DQ/2) = -106% *Q1 – (106%*DQ)/2153% * DQ = -106% *Q1DQ = -(106%/153%)*Q1 = -69.3% * Q1[1] Wang, George and Jat Yau, 2012. “Would a Financial Transactions Tax Affect
  4. 4. [1] Wang, George and Jat Yau, 2012. “Would a Financial Transactions Tax AffectFinancial Market Activity? Insights from the Futures Market, “ Washington, DC: CatoInstitute, available at[2] This calculation assumes that 100 percent of the tax is passed on to traders. This islikely not to be true.[3] The product of the elasticity and the percentage change in price would have toexceed 2 for a market to be completely eliminated by a tax.Comments (0) Subscribe to this comments feed Show/hide commentsWrite comment(Only one link allowed per comment) Show/hide comment form Powered by Azruls Jom Comment for Joomla! Home | Research Topics | Jobs/Internships | Contact | Log-in 1611 Connecticut Avenue, NW, Suite 400, Washington, DC 20009 | 202-293-5380 ***This site best viewed using Mozilla Firefox***