The US government has a budget deficit. In fact, it’s kind of a large deficit. As Congress looks for ways to reduce that deficit, one of the ideas that has come up is a financial transaction tax, or “Tobin tax.” In fact, Democrats Tom Harkin and Peter DeFazio have suggested that a small tax on every stock transaction could raise over $325 billion over the next ten years. Specifically, they argue that a transaction tax would not only provide significant revenue gains but would also curb high-frequency trading.

Supporters of a more ambitious plan in the European Union claim that a 0.1% tax on stock transactions, combined with a 0.01% tax on derivatives, would raise over €50 billion (PDF) to €500 billion (PDF) annually (the wide range is largely explained by assumptions about the ability of investors to avoid the tax by moving their transactions to the United States). To put those numbers into perspective, €50 billion is about 10% of the estimated 2013 budget deficit.

For many people, cutting the budget deficit by 10% without taking money away from the schools that teach the children of our soldiers or slightly inconveniencing air travelers would be nothing short of miraculous. But for many economists, the plans to create a Tobin tax in Europe are misguided attempts to punish banks and investors for the financial crash and would actually lead to more volatility in the markets. Particularly as applied in the United States–where politicians have specifically singled out “high-frequency traders” as a reason for a Tobin tax–plans to tax financial transactions seem more about scoring political points than about solid tax policy.

Generally, the idea behind a Tobin tax is to punish low-information investors, essentially raising the cost of gambling to dissuade trades that create “noise” in a market (PDF). By adding a surcharge to every stock purchase, someone without any real reason to believe that a stock will appreciate (i.e., a “gambler”) will be less inclined to enter the market. However, someone with real information (i.e., a “speculator”) would still enter the market, since his information, if good enough, should generate enough profit to offset the small tax penalty.

The EU proposal seems to be in line with this premise: it doesn’t target any specific activity, focuses on having multiple countries adopt it (which keeps investors from dodging the tax), and takes its cues from the tried-and-tested transaction tax in the United Kingdom (paywall).

The Harkin-DeFazio proposal, on the other hand, seems slightly misguided. Its transaction tax would definitely curb high-frequency trading, but that may not necessarily be a useful goal.

High-frequency trading (HFT) is a form of trading enabled by advancements in electronic trading. Since orders to buy and sell can be entered electronically and directly into exchanges, some firms have focused on creating complex algorithms that can handle thousands of trades every second. Instead of front-running by hiring traders who could actually outrun the competition, HFT leverages the speed of electronic connections to anticipate and front-run, making profits by anticipating where the market will be in the very near future (in order to speed up the delivery of orders, some traders pay to put servers in the basements of exchanges to reduce latency). Many politicians–and voters–believe that this technological edge is unfair and actually threatens the viability of the stock market.

However, HFT actually provides many benefits to the market. HFT accelerates price discovery and increases market efficiency, as the high speeds and large volume of the trading makes market prices react faster to large orders. Moreover, high volumes of HFT trades greatly enhance market liquidity. While highly publicized “flash crashes” have been blamed on HFT, most of the negative effects of “flash crashes” actually occurred once HFT traders left the market. The absence of HFT hurt liquidity so much that prices fell because there were no longer buyers (PDF) for unwanted stocks or futures contracts.

What do you think? Does allowing HFT benefit the market? Or is it an unfair technological advantage that should be regulated? Does it matter that Getco, the highest profile high-frequency trader, saw a significant slip in profits in the past year? How should Congress react to the growing development of dark pools? And are dark pools even caused by HFT?

–Jacob Marshall

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