Yesterday, I read another article about enacting a transaction tax in Chicago to solve the city’s financial problems. There are alderman in the Chicago city council that want to enact a transaction tax. The Chicago Teachers Union is lobbying for a transaction tax. This idea is one of the most idiotic ideas I have ever heard.
It has no basis in any economic thought. It doesn’t even have basis in socially responsible thought. People that latch on to the idea are like insects that flirt with a Venus Flytrap flower.
Every once in awhile, the transaction tax makes its way into the President’s budget, or a Congressional budget. For a long time, it was just ingrained in the software and it would always be eliminated. I am not sure today, but I haven’t heard the national government trod down the same misguided path in a long time. Maybe it’s just Republicans control the house because the tax is traditionally a Democratic idea.
Here is an excerpt from the article:
In June, Joan Kufrin sent a letter addressed to the state’s four chief political leaders and to the editorial boards of the downtown dailies. Noting that state rep Mary Flowers had proposed a financial transaction tax in 2013, Kufrin wrote, “Had it been enacted into law, in 2014 this penny tax on financial transactions would have raised $116.1 billion for the state with $11.6 billion coming to Chicago.
The author of the article, Ben Joravsky, goes through some emotional and normative economic analysis to justify the tax. When someone makes normative, or emotional arguments, it is impossible to persuade them with facts. I won’t try and persuade Ben, but hopefully I can enlighten everyone else. When you hear about a transaction tax you will tell the person proposing it that they are stupid. Don’t couch your words or tone when it happens.
First, a tax like this is a tax on capital. The tax on capital would mean that there will be less volume on the bid/ask spread. The spread might also become wider. Here is what that means in real terms.
Suppose the bid/ask spread on the 3 month Eurodollar was one tick. That tick is worth $25. A typical bid/ask spread would be 95.00 bid at 95.01 offer.
If I normally was a 100 lot trader, meaning I would be willing to buy Eurodollars at 95.00, or sell them at 95.01. If I bought 100 at 95.00, and sold them at 95.01, I make $2500 gross. A tax would cause me to change my size. At a penny per contract it increases my cost by $1. As a member trader, my all in cost of trading one side (a buy or a sell) of a Eurodollar contract breaks down like this.
CME Commission .09
Globex Commission .10
FCM Commission .20
Double the cost for the other side to close the position.
More unallocated costs are the monthly cost for a front end software for trading which can run up to $1000 per month depending on the bells and whistles. Data also costs a lot of money per month. There is also your office cost per month. Traders don’t buy the cheapest internet service, they get very high speed internet. These vary from trader to trader but they are not insignificant. Let’s assume the all in cost of these things is $1800 per month and I typically trade 7500 round turns per day. That’s an extra $4.16 per contract in fixed overhead.
Adding the tax increases my cost by .01 to .40, or .80 per round turn. That doesn’t sound like much. But, over the course of a year, it’s a lot. Typically, the average daily volume of Eurodollars is over 2 million contracts per day. When I traded Eurodollars, typically I traded between 5000 to 10000 round turns per day. At 5000 round turns the tax would cost me $100, and at 10000 it would cost me $200. 220 trading days in a year and the tax would have cost me $22,000 to $44,000. That might be a month worth of gross earnings for an independent trader.
For a company that is engaged in HFT, this tax will cost them millions per year.
Does anyone know what’s priced off of the Eurodollar price? Home mortgages, short term business loans, and even student loans. A tax will cause less volume to be on the bid/ask spread. If you want to move a larger number of contracts, you will confront what is called “slippage”. Slippage is the true cost of a trade. Suppose I want to sell 1000 contracts at 95.00. But because the tax is there, the bid is only for 200 when it used to be for 1000. Now the order might have to go as low as 94.95 to get filled. That adds in a cost of $25 per contract at every tick move down.
That cost isn’t only borne by the trader. It’s borne by the couple that are refinancing their mortgage. It’s borne by the person getting a business loan. If we extend this logic to everything, it’s borne by the person buying a loaf of bread or gallon of milk, or gallon of gas. It’s shouldered by the federal government when they go to auction off treasury bonds to pay for the ever expanding federal debt-which in turn is borne by the taxpayer since treasuries are a claim against our future income goes to pay off the debt.
What the advocates of the transaction tax clearly don’t understand is the risk versus reward of trading. It’s not as if every day a trader wakes up and shakes the money tree everyday in the backyard and proceeds to scoop up money in bushel baskets. Trading is extremely risky. Most people don’t have the stomach for it, nor are they successful at it. If it was risk free and easy, everyone would do it.
Remember, this isn’t the only tax traders pay. They pay a blended 60/40 tax on income which is around 27%. They pay a self employment tax, and they also have to pay 12% for FICA. They pay state income taxes. I know everyone pays taxes but it’s a lot easier to budget for them when your income isn’t variable.
Futures traders also pay taxes on the settlement price December 31 if they have an open position. One year, I had a very large profitable open position on December 31. I paid my tax on the mark to market settlement price. For the first three or four trading days of January, the market was lock limit up. I couldn’t get out of my position and gave back about 3/4 of my profit on it. Yet, I still owed the tax. Fortunately for me and my family the market turned around and I made back what I lost plus some more.
I can tell you plenty of stories about losing money trading. There are no guarantees from day to day, or from year to year that you will even have positive income. Each year, your income varies. The more money you make, the more volatility you will have in your earnings. For example, if I am a trader that takes a bunch of risk and makes $1M one year, the probability of me making the same amount of money the next year is significantly lower than 50%. Market conditions are always in flux and if I am trading big enough to earn $1M, I am trading big enough to lose a lot more than that. One time my friend and I had a similar position and they had a lot bigger one than me. Their margin call to hold the position was over $10M dollars.
If you want to make $1M trading, it takes a lot of capital. Way more than $1M.
If Chicago successfully executes a transaction tax, here is what the fallout will be.
- All the financial exchanges will leave the city, and most probably the state.
- Every single person engaged in trading activity will leave the city and state. That means not just futures traders but equity traders, option traders, forex traders and probably a lot of broker/dealers.
Chicago won’t see one penny of the tax. It’s budget will be totally blown because of the black hole left by all the exiting individuals and businesses. Chicago won’t become Detroit. It will be worse than Detroit with a better view. Chicago has a pension budget hole in the billions of dollars and the state of Illinois is worse. Did I mention Cook County?
In the book City of the Century, my friend Professor Don Miller clearly articulated how Chicago was built from 1840-1900. Chicago would have stayed an ink spot on the map if it wasn’t for the invention of the warehouse receipt. That allowed for fungibility of grain in warehouses, which in turn made it possible for the CBOT to be established in 1848. That caused railroads to be built and Chicago beat St. Louis as the epicenter of the Midwest.
People came to Chicago to take risks. Many profited. They took that money and they invested in the cultural icons many Chicagoans hold dear. The Art Institute was built with trader money. The Auditorium Theatre was built with trader money. Chicago owes its entire existence to the exchanges that started here. It continually benefits from having those exchanges in the city today. There are numerous network effects that happen outside of the bartenders and barbers having jobs.
The other thing that I never see in a budget offered up by progressives/liberals is actual cuts in spending or elimination of programs. They will change 5% growth in the budget to 3% and call it a cut, but the fact remains that the budget still grows. I never see anything resembling real pension reform in a progressive/liberal budget either.
Why don’t progressives understand all this? Transaction taxes are a fool’s errand.