Why a financial transactions tax is a no-brainer

March 22, 2013, 1:26 PM UTC

FORTUNE — Short-termism, too big to fail banks, and a bloated financial sector. Insider trading, flash crashes, and a casino-like market. Proprietary trading fiascos, like J.P. Morgan’s (JPM) London whale.

There are many, many reasons Vanguard founder Jack Bogle and over 1,000 economists and financial industry professionals support a financial speculation and derivatives tax (aka financial transactions tax). But U.S. taxpayers and people who care about our capital markets should pay close attention to the flawed arguments that the opposition is putting forward.

On February 28, Senator Tom Harkin and Congressman Peter DeFazio reintroduced a bill that would impose a speculation and derivatives tax that could bring in needed government revenues. The short, readable bill proposes a modest 0.03% tax on stock, bond, and derivatives trades. The bill excludes initial capital raising, addresses tax collection concerns, and provides a tax credit offset for contributions into 401(k)s and other health, retirement, and savings accounts. The reintroduction of the bill follows recent announcements that 11 European Union countries plan to implement new speculation taxes.

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Two days before the bill was reintroduced, a New York Times article by Steven Davidoff laid out various claims against speculation taxes. As the Times article demonstrates, there are several spurious arguments we should keep an eye on in the months ahead.

1. Outdated studies

Some speculation tax opponents like Davidoff are advancing their arguments with out-of-date studies. But, in the case of a speculation tax, it’s important to recognize that our markets have changed dramatically over the past few decades. Given all the changes over the past three decades, Davidoff citing a study of the impact of New York financial transaction taxes from 1932 to 1981 is interesting from a historical perspective but not much more. Even Daniel Weaver, one of the New York tax study’s authors, told me: You “can’t make a direct comparison from 1981 to now.”

Bogle told me that he favors a speculation and derivatives tax precisely because of market changes “in the last quarter century” and the fact that “we’ve taken almost all the friction out of the system.” Dramatic cuts in brokerage commissions, the decimalization of share prices, and narrower bid/ask spreads, along with reduced capital gains taxes are all examples, Bogle says. “Frictional costs are inconsequential now” and “speculation is no longer discouraged,” he told me. High frequency trading has also become a real problem. The May 2010 flash crash destabilized the markets and eroded confidence in the system.

2. Cherry-picked examples

Some opponents of a speculation tax also ignore the vast evidence the EU has amassed in support of such a tax and cherry-pick poor examples. U.S. markets are very different from those of, say, Sweden, which apparently lost trading volume to Britain when it passed a financial transaction tax. There’s no real basis to say investors will behave the same way in the U.S., Bogle argues.

3. Numbers that tell tall tales

Numbers can tell all sorts of stories, some accurate, others not so much. According to the Times, a BlackRock report “has calculated that if the financial transaction tax were set at 0.1% per trade, an investor putting $10,000 in its global equity fund would lose more than $2,300 in expected returns over a 10-year period. This amount would rise to $15,000 if the money were invested in a more actively managed European fund.”

That’s using a tax rate more than three times the 0.03% Harkin and DeFazio are recommending. Joanna Cound, one of the authors of the BlackRock study, says that the time period for the calculation was 20 years, not 10 as the Times had reported — so the ding, on average, would be $115 per year in the global equity fund. Also, BlackRock assumed that the fund achieved 150 basis points over its benchmark every year for 20 years — nice returns if you can get them (thus resulting in more dollars to trade).

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So how much churning would have to occur in your U.S. portfolio to pay out, say, $1,500 in taxes? It turns out you’d have to burn through $5 million in trades to pay that much. While this might bother some speculators, investors in most of the Money 70 don’t go in for that kind of turnover — and have nothing to worry about: $10,000 in trades would cost just $3.

So, should we have a tax?

Many financial speculators will assert that’s the question — but it really isn’t. The SEC already gains some of its funding through such a tax mechanism, a fact that many people don’t know.

The real question is will the 0.03% that Harkins and DeFazio are proposing be enough?

You can view the speculation and derivatives tax as a kind of sin tax. It treats casino-like speculators much like tobacco taxes treat smokers. Ideally, it will raise revenues to help fund efforts to combat the speculators’ ill effects, while also potentially shrinking the public hazards by reducing their prevalence.

But to do both, we need a tax large enough not only to acquire the needed revenue but to encourage behavioral changes as well. If we implement a tax that is too small, sure as the sun rises every morning, the naysayers will say, “You see, we were right. It is ineffective. It didn’t do what it was s’pose to.”

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