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The Impact of a Financial Transactions Tax on Futures
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Briefings/Testimony Written by Dean Baker
Scorecard Series Thursday, 21 March 2013 15:21
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One of the reasons that many proponents give for supporting a budget economy
Films 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 care
En Español
housing housing bubble
Em Português First it may reduce the likelihood of erratic fluctuations that have no basis in the inequality jobs
Other 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 market
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occurrences.
OccupyWallSt paid
En 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 retirement
Em Português
Social Security taxes
in trading are resources that could in principle be used productivity elsewhere in the
Other 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. future is $14.80. It calculates that the 0.02 percent tax on a future, with an average
price of $283,981 in 2010 would increase transactions costs by $56.80, or 383.8 percent
of the pre-tax transactions cost. The paper relies on prior work that estimates an
elasticity of trading in the S&P 500 futures market -0.81. Applying the point estimate
method to calculate the change in trading volume it multiples the percentage change in
price times elasticity, which gives:
D Q = 383.8% * (-0.81) = -310.9%
In other words, this completely eliminates the market since trading volume declines by
more than 100 percent.
However, if we applied an arc elasticity then the percentage change in would be -69.3
percent (see appendix for this calculation):[2] This is of course a very large drop in
trading volume, but would still leave a market with annual trading of $670 billion, down
from a pre-tax market volume of over $2 trillion.
In fact, if the correct methodology was applied to the other futures contracts shown in
Table 2 in the paper, it is unlikely that any markets would actually disappear as a result
of 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 to
completely eliminate the market. Even when elasticities are slightly above 1, it would
take 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 a
tax of 0.02 percent would eliminate the market this means that the value of trades in
this market is less than 0.02 percent of the price of futures contract being traded. While
this is likely true for many of the trades in the market, it is unlikely to be true for all of
the trades.
Futures contracts do serve an economic purpose and it is unlikely that the actors in the
market who are buying contracts for their actual purpose (e.g. farmers wanting
insurance on crop prices or airlines wanting insurance on jet fuel costs) would abandon
the market completely if the price of the contract were to rise by 0.02 percent of the
nominal value of the contract. In fact, since many of these futures markets have existed
for many decades, when transactions costs were far higher than they would be now
even with a 0.02 percent transactions tax, it is not plausible that this tax would
eliminate the market.
The fact that trading volume would tumble as a result of the tax is likely consistent with
how most supporters of FTTs would view its impact. The FTT would eliminate a large
amount of short-term and speculative trading, while still allowing a large enough volume
of trading for the markets to serve their purpose. In this case, the tax on this single
futures contract (which has one of the lowest trading volumes of the futures contracts
shown in Table 2 of the paper) would still raise $135 million a year in revenue each year
and almost $2.0 billion in the 10-year budget window.
The incidence of this tax falls overwhelmingly on the financial industry, even in this case
where we have assumed that 100 percent of the tax is passed on to traders in the form
of higher costs. Previously traders had been paying $114 million a year in transactions
costs on S&P 500 contracts, according to the estimates in the paper. After the
implementation of the tax they would be spending $168 million a year, including the
tax. This means that the government would be collecting $133 million annually while
traders 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 a
modest portion of the tax (e.g. 10 percent) was eventually passed on to the financial
sector in the form of lower fees per transaction. This seems plausible since the sharp
drop in demand for services from the sector is likely to lead to some decline in the
wages and prices in the sector. In this case the reduction in trading volume would be
slightly less, with volume falling to $710 billion a year. The tax would then $142 million
a 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 trading
would be just $161 million a year, just $47 million more than before the tax was put
into place. In this case, financial intermediaries would bare 64 percent of the incidence
of the tax ($91 billion/ $142 billion).
Table 1

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 NA
After-tax -- 100
0.7 34.8 133.0 167.8 59.6%
percent pass through
After-tax 90-percent
0.7 23.0 141.7 164.7 64.2%
pass through
Source: Author's calculations, see text.
The trading that is eliminated can be viewed as a waste of resources. The resources
released by the reduction in trading volume will then be available for use in productive
sectors of the economy.
It is worth noting that situation would look better from the standpoint of traders for
assets where the demand is more elastic, since this means that the same percentage
tax increase would result in a larger decline in trading volume. The estimate of elasticity
for S&P 500 contracts is lower than all the other estimated elasticities that appear in the
Wand and Yau paper, except for home heating oil. (The elasticity on future contracts for
home 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 intermediaries
for these other contracts.
Conclusion
A modest financial transactions tax will lead to a sharp falloff in trading volume for many
types of financial instruments. However it is unlikely to eliminate markets altogether
except in cases where the instrument provided very little value to the economy. The
decline in trading volume is one of the goals of the tax both since it may reduce
volatility in financial markets and reduce the amount of resources consumed by the
sector, freeing them up for productive uses elsewhere in the economy. The greater the
elasticity of demand in a market, the larger the portion of the tax that will be borne by
the financial sector rather than end users. In almost all cases, the financial sector is
likely to bear the vast majority of the burden of the tax resulting in considerably lower
wages and profits in the sector.
Appendix
Working 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 using
the 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)/2
153% * DQ = -106% *Q1
DQ = -(106%/153%)*Q1 = -69.3% * Q1
[1] Wang, George and Jat Yau, 2012. “Would a Financial Transactions Tax Affect

4. [1] Wang, George and Jat Yau, 2012. “Would a Financial Transactions Tax Affect
Financial Market Activity? Insights from the Futures Market, “ Washington, DC: Cato
Institute, available at
http://www.cato.org/sites/cato.org/files/pubs/pdf/PA702.pdf.
[2] This calculation assumes that 100 percent of the tax is passed on to traders. This is
likely not to be true.
[3] The product of the elasticity and the percentage change in price would have to
exceed 2 for a market to be completely eliminated by a tax.
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