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Rekenthaler Report

Which Is Better or Worse: The Financial Transaction Tax or the Capital Gains Increase?

Assessing the current proposals before Congress.

On the Table

Washington Democrats are considering two motions to boost investment-related revenues. One is a financial transaction tax, or FTT, which would apply to the transactions of stocks, bonds, and derivatives. (Whether the FTT would exempt purchases and redemptions of funds that own such securities is unclear.) The other proposal, touted by President Biden during his speech to Congress, is to hike the capital gains rate on taxpayers who earn more than $1 million.

The FTT is a recycled regulation. From 1914 through 1966, the United States imposed a transfer tax on equity sales that was significantly above the current proposal's amount. In contrast, while the capital gains rate has fluctuated, it has never exceeded 35%, and reached that level only briefly. The president's suggestion goes where the U.S. has not yet been.

This column's question: If the nation were to adopt one of the two proposals, which would be preferable? Which program would best increase federal revenues while minimizing adverse consequences?

The FTT

Let's start with the FTT, which both Bernie Sanders and Elizabeth Warren pitched while on the campaign trail, and which this column discussed last summer. Sanders' version of the FTT would levy a 0.5% tax on stock trades, with lower surcharges for bonds and derivatives. His suggestion exceeded the historical rate, which began at 0.2% and was later increased to 0.4%. In contrast, Warren advocated the considerably lower figure of 0.1%, for all three investments.

Warren's approach is the one adopted by Senate Democrats. It is accompanied by nonpartisan analysis, as the Congressional Budget Office evaluated the proposal in 2018, reckoning that it would increase federal revenues by $800 billion over 10 years. Skeptics will respond that such studies inevitably underestimate the revenue-depleting effect of innovation, as investors discover new ways to conduct their old affairs. The cynics are correct; it would be prudent to shave the CBO's forecast. Still, even a prominent critic, the center-right Tax Foundation, concedes that enacting an FTT would generate a "substantial revenue source."

Objections to FTTs land in two camps: 1) concerns about everyday investors, and 2) fears about market structure. The first, to be kind, is a stretch. The typical large mutual fund turns over about 30% of its portfolio per year. Its yearly FTT bill would therefore be a modest 3 basis points--$60 on a $200,000 account. Admittedly, retail investors who flip stocks would pay more. But even in their case, the tab would not be insurmountable. The FTT expenditure for those who turn over their entire portfolio each month would be 1.2% annually.

The concern about market structure is not so easily dismissed. Implementing an FTT would create complications. For example, it would squeeze exchange-traded funds, which swap securities in response to their shareholders' activities. More dramatically, the tax would outright eliminate high-frequency traders, who would be ruined as surely as if they sold fax machines.

Whether the latter should be mourned is open to question, but the point remains: Introducing an FTT would affect the operations of the world's leading financial marketplace. Presumably, the adverse consequences could be alleviated by carving out appropriate exceptions within the regulations, so such worries can be addressed. However, avoiding problems would require legislative care.

(As discussed by Morningstar's Lia Mitchell, implementing an FTT would benefit passive management, given that active managers typically have higher turnover rates. However, as the typical actively managed U.S. stock fund could pay the FTT's entire cost by cutting its expense ratio by 5 basis points, the problem has a ready solution.)

Capital Gains

The capital gains measure is a smaller affair. Some, in fact, allege that the rule's outcome would be negative, meaning that the government would collect fewer revenues. Worryingly, the University of Pennsylvania's Budget Model forecasts that, unless the capital gains increase is accompanied by a change in how estates are treated, government receipts would decline by $33 billion during the next decade. That result would be a small-scale disaster. 

To be sure, the Budget Model calculates that eliminating the step-up in cost basis that now occurs at inheritance--a provision that is contained within Biden's current proposal, as discussed recently by Morningstar's Christine Benz--would reverse its forecast. Banning the step-up would increase tax revenues over the decade by an estimated $113 billion, rather than reducing them. That would be a step in the right direction, but only a step, given that the financial transaction tax would raise at least 5 times as many revenues.

Regrettably, removing the step-up would cause knock-on effects. It would damage the tax math for those inheriting real estate, family businesses, and farms. Under certain conditions, the change could also oblige legatees to make forced sales of their newly inherited securities in order to pay their estate taxes--an action that would then trigger the capital gains tax, thereby forcing them to sell additional shares. A vicious circle that would be.

As with the drawbacks of the FTT, these issues are also resolvable. For example, the time required to pay the estate tax could be extended to five or even 10 years, thereby giving the legatee the time to raise the required funds while not under immediate duress (and while being less likely to trigger the higher capital gains rate). Others have suggested that the private market could fulfill the need by devising new forms of insurance.

Ultimately, then, the largest objection to boosting the capital gains tax is the same as with the financial transaction tax: Is the extra revenue worth the risk to the financial market's structure? Although the president's capital gains proposal would affect only 3% of taxpayers, those investors generate more than 60% of individuals' capital gains. Passing the legislation would give a great deal of money a strong incentive to stay put, thereby imperiling market efficiency.

In Conclusion

Within the U.S., neither a financial transaction tax nor an increase in the capital gains rate is a radical idea. The former would resume previous policy, while the latter represents a change in magnitude but not in direction. Globally, though, the FTT is the more mainstream suggestion. China, Hong Kong, and France currently impose similar surcharges. Meanwhile, no major bourse has a capital gains rate that approaches 40%.

Thus, both from the perspective of raising revenues and of avoiding unforeseen difficulties, the FTT seems the more attractive of the two proposals.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.