Will Transaction Taxes Reduce Leverage?

The chairman of Britain's FSA wants to radically shrink the financial sector, and says he's willing to do so by any means necessary, up to and including a "Tobin tax". Kevin Drum likes the idea:

As for the transaction tax, I don't know how practical that is. But if it can be made to work, it's a good idea. Not only would it raise some money, but it would put a crimp in some of the most highly leveraged investment schemes, which fundamentally depend on tiny returns multiplied by billions of dollars. A transaction tax would make a lot of them unprofitable. So it's a twofer.

I'm not precisely clear on what Lord Turner means by a Tobin Tax, which is technically a tax on currency transactions. Once you get beyond there, it's sort of vague as to how and where you would apply such a tax.



But any sort of feasible tax is not going to reduce highly leveraged investment schemes.  I mean, if you're taxing debt issuance, it will increase your interest rate or the points on the loan, which might put some pressure on leverage.  But I don't think by that much.  You're talking about forcing someone to reduce their leverage from 20-to-1 to 19.8-to-1.

What a transaction tax makes less profitable is a portfolio strategy that relies on lots of quick trades.  I suppose there's a valid question about how much social value those folks provide, though you have to admit that they do at least increase the speed of the price information available in the markets, and to some extent their liquidity, which most people regard as a good thing.  But that's not going to stop anyone from borrowing vast sums and plowing them into highly illiquid assets like complex mortgage-backed securities.  That being approximately what everyone is complaining about in the current crisis.

What such a tax would also do is make a lot of people freak out.  If you tax debt transactions, you've suddenly got more points on your mortgage, your money market account stops paying much of anything, your credit card comes with a hefty annual fee, and businesses small and large have more trouble borrowing short money to cover temporary cash flow issues.  If you don't tax debt transactions, the largest effect of the tax will be to punish actively traded investment funds.  The academic literature indicates that this is stupid behavior that already is punished by sub-par returns, but it's not a social threat that looms large.

Lord Turner undoubtedly knows a lot more about finance than I do, so it is possible, even probable, that I am missing something.  But until I hear some more convincing explanation, I am officially skeptical.  If his quite sensible preferred strategy of higher capital requirements doesn't reduce the amount of unhealthy leverage in the system, I fail to see what a tax will add except, well, a tax.