Since GDP equals the money supply times the turnover of money -- what economists call velocity -- a fully effective transactions tax will presumably reduce velocity. Consequently, it would be severely deflationary unless the Federal Reserve substantially increased the money supply to compensate. It also means that the tax base will shrink as soon as the tax is imposed.
A recent study by the International Monetary Fund of real world experiences with financial transactions taxes comes down very hard against them. For starters, by targeting the means of payment, a transactions tax will hinder development of a nation's financial system -- which all economists believe is critical to economic development -- and lead to disintermediation from the banking system. Primitive economies use cash and barter; advanced economies use checks, credit cards and debit cards. So why would we want to encourage people to use primitive financial methods and discourage them from using advanced methods?
The study notes that wealthy people were able to avoid transactions taxes by using offshore financial institutions and businesses did so by vertically integrating in order to keep transactions in-house and not utilize the banking system. It also found that governments often penalized themselves with such taxes because much financial activity involved trading in government securities. The tax raised interest rates, thereby forcing governments to pay more to finance their debts.
The problems of transactions taxes have always caused them to break down within a short time. Generally, they have been instituted only in relatively undeveloped nations experiencing extreme financial crises that demanded a large, temporary injection of revenue. There is no reason to think that financial transactions taxes could form the foundation of a tax system. "The use of these taxes should be avoided," the IMF study concluded.
The nominal rate of taxation is very important, but it is only one factor in determining how burdensome a tax is. If the same income is taxed over and over again, the effective tax rate will be far higher than the statutory rate. Or if the tax base is badly defined, then a low tax rate can be much more debilitating than a higher rate on a proper base.
The only attraction of a financial transactions tax is the low rate. But it is a chimera and would have many undesirable economic consequences if enacted. We should stick to taxes we better understand and know will work in the real world.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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