Speculators won’t be the only ones who will pay the price if a proposed levy on stock trading passes, says Wall Street guru Burton Malkiel. By Anne Kates Smith, Executive Editor February 7, 2010 President Obama has proposed levying a tax on big banks to help pay for their bailout and rein in deficits. But another measure before Congress, a bill to create a financial-transaction tax on stock and derivatives trading, is likely to be far more consequential. Supporters say the measure would raise $150 billion a year and curb the kind of speculative trading that got us into trouble in the first place. The math -- at least for Main Streeters -- is simple and not scary at all, says Dean Baker, co-director of the Center for Economic and Policy Research, a think tank in Washington, D.C., and an outspoken proponent of the tax. The proposed tax of 0.25% on the sale or purchase of a share of stock would cost the investor $25 on a transaction valued at $10,000. If the share price doubles in ten years and the investor sells, he or she will have to pay $50. If the investment is held in a taxable account, capital-gains taxes would dwarf the transaction fees. Most long-term investors would barely notice the fees, says Baker. Plus, the proposal would exempt the first $100,000 in trades per year, as well as trades made in mutual funds and in tax-deferred accounts, including retirement, education-savings and health-savings accounts. While overall trading volume would likely be reduced, perhaps pushed back to levels of 20 to 25 years ago, Baker and other supporters say the lost activity represents gambling, not investing. But Burton Malkiel, a Princeton professor, author and longtime Wall Street guru, disagrees. He recently spoke to Kiplinger to explain why. Advertisement KIPLINGER: You say proponents of a financial-transaction tax misunderstand the market. How so? MALKIEL: I think they see this as a tax that will fall only on speculators who serve no useful purpose -- who are not helpful to the market and who simply create volatility. That’s basically incorrect. The misunderstanding is in the proponents’ view that it is useless speculators creating all the volatility in the market, when in fact it is useful arbitrageurs making the market more efficient. A further misunderstanding is that somehow the public is hurt by all of the trading, when quite the opposite is true -- the public is helped. How are we helped? In two ways. First, the market is made more efficient, and second, it is made more liquid. Because the market is more liquid, investors can benefit from lower transaction costs. Advertisement Explain, please. Here’s an example. We know that one of the most popular exchange-traded funds is SPDR S&P 500 ETF (symbol SPY). It’s an index fund that tracks Standard & Poor’s 500 and trades like a stock. We also know that S&P 500 futures contracts are actively traded. But the future might trade at a slight premium over the prices of the underlying stocks as they’re traded on the exchange. Or the ETF might trade at a slightly higher price than the 500 stocks. To capitalize on the discrepancy, the arb sells short the ETF or the future and buys the underlying 500 stocks, bringing the future and the ETF in line with the value of the underlying stocks, thus making the market more efficient. It means that the ETF will be appropriately priced, the future appropriately priced and that people coming into the market to, say, buy the ETF will get a fair price. And what did you mean about transaction costs? Over time, as volume has exploded, bid-asked spreads -- the difference between the price traders will pay for a stock and the price they’ll accept for selling one -- have shrunk. That’s the real cost of trading, the bid-ask spread. The fact is that you buy at the asked price and sell at the bid. Suppose spreads widen as the result of a tax on trading -- and there is not a doubt in my mind that as trading diminishes spreads will widen -- then you’ll pay more in transaction costs. You’ll pay more to buy and receive less when you sell. Advertisement But how will individuals be hurt if the tax, as proposed, exempts mutual funds as well as retirement savings, college savings and health savings accounts, and the first $100,000 worth of trades? If spreads widen, it will hurt all individual investors who invest through mutual funds, all 401(k) investors, all IRA investors. As money comes into a mutual fund and the fund has to buy securities, it, too, will pay more in transaction costs. Investors often misunderstand the importance of transaction costs because they’re not reflected in expense ratios. But in the end, paying more in trading costs means total returns are lowered. Didn’t the U.S. have a similar tax on stocks until the 1960s? We sure did. But back then we had much less trading and bigger bid-asked spreads. In England and in other countries that have a similar tax, there is much less trading and bigger spreads. Not having a tax here is one of the reasons our markets are the most efficient in the world. Even with the struggles of the dollar, people are still trading here. It’s why the dollar is able to remain the world’s reserve currency -- people all over the world know that our stock and bond markets are the most efficient. Advertisement This tax has some pretty notable supporters, including Vanguard founder and mutual fund guru Jack Bogle. I agree with Jack Bogle on probably 90% of the things he's for -- on this I disagree with him. Do you think a financial-transactions tax bill has a chance of passing? I'm not the best person to ask about the politics of things. But everyone is so angry at Wall Street that it’s quite possible this will go through.