Representative, Peter DeFazio is at it again.  With support from Senator Tom Harkin, the two US lawmakers will introduce a bill today to propose a transaction tax on financial transactions. (See Bloomberg article here).

DeFazio tried to propose a similar tax a couple of years ago, but the proposed bill never gained much traction.  But now that the European Union has proposed a financial transaction tax, DeFazio is hoping that his proposal can gain more support this time around.

The problem is this tax, while in theory, would raise a substantial amount of revenue, it would come with some substantial costs, the most significant being a decline in market liquidity.  Market liquidity refers to a stock’s ability to be sold without substantially impacting price.  The majority of our market liquidity is provided by market makers.  These market makers have very small profit margins.  A modest transaction tax of 0.03 percent (which is being proposed), would have devastating effects on the market making business.  Let’s take a quick look at the math.

Many of our most highly traded stocks have bid-ask spreads of one cent.  A stock that is trading at $25, would have a transaction tax of ($25 x 0.0003) = $0.0075 per share.  If a market maker were to buy this stock at $25 and sell it at $25.01.  They would make 1 cent/share, but would have to pay 1.5 cents/share in tax (they have two transactions, the buy and the sell).  Therefore they would lose 0.5 cents on the transaction.  In order to remain profitable they would have to widen their spreads to a minimum of 2 cents, and possibly further (as market makers aren’t always profitable on every trade).  Wider spreads means more price impact for institutional traders as they make trades, which comes right out of the pocket of the little guy who invests in the fund that is trying to transact.  These are the indirect costs.

The direct cost is that the institution transacting would have to pay the transaction tax as well.  So another 0.03 percent comes out of the pocket of the individual investors investing in the fund, every time the institution makes a trade.

What will naturally happen is that traders and institutions won’t trade as much, and volumes will drop substantially.  This makes any projected revenue raised by the transaction tax much less than what would be raised on today’s current market volumes.

Some will argue that introducing this tax will eliminate high frequency trading.  Now I’m not a big fan of high frequency trading either, but there are better ways to regulate high frequency trading.  This tax would do nothing more than harm market liquidity in a market environment that some already argue doesn’t have enough liquidity to begin with (think of the May 6th flash crash).

So let’s use some common sense when introducing bills that do more harm than good.