Thursday, December 10, 2009

What Is So Sacrosanct About the Stock Market?

Greg Mankiw picked up a piece by his old prof, the one who wrote A Random Walk Down Wall Street, who recently argued that a transaction tax on the stock market will kill the economy by discouraging stock market speculation and hence the inflow of cash into the US to fund its budget deficit. Is the stock market so sacrosanct?

The only major reason for economists to argue that there should be no tax on stock market incomes is that there is no value add in stock market incomes - that the people involved in the stock market do not add any value to the economy. What they are engaged in is merely the transfer of income from one pocket to the other.

But the current argument by the stock market guru that there should no a transaction tax on stock market trading because it will hinder the functions of the stock market.

"Transactions taxes would make most current high-frequency trades unprofitable since they depend on the thinnest of profit margins. Trading volume would collapse, and there would be a dramatic shortfall in the tax dollars actually collected by the government. Market liquidity would decline, bid-offer spreads would widen, and all investors would pay significantly higher costs on their trades."

But brokers do get paid for doing transaction work for investors. But the article argued that transaction costs have come down due to technology and a transaction tax on stock market trading will raise the transaction cost and make that market uncompetitive.

So the argument is really not about whether there should be a tax or not, but how much.

Which means that the stock market is not sacrosanct.

The stock market survives on two major factors in descending order of importance:
1. Value of the companies on the stock market. No amount of speculation will raise that intrinsic value which is based entirely on correct investment and value addition.
2. Liquidity which will arise if the corporate values are intrinsically good and when the central bank becomes silly by pumping loads of cash into the system to inflation market prices which result in a diversion of focus from investment in companies to speculation in the stock market.

We have seen from the Malaysian experience of the 1990s, and the US and Europe today, how an extremely active stock market has ruined the resolve of corporate investors in undertaking proper business plans.

In a highly liquid global market that we are in today, the fear of not illiquidity but lack of investment ideas - which leads to an oversupply of the same old stuff that everybody has already.

Furthermore, the stock market leads to a massive redistribution of wealth (since there is no income generated), and a transaction tax can be seen as a mild wealth tax, on the argument that traders on the markets are savers and investors with the wealth to invest.

A transaction tax will hopefully divert investor focus from the frail financial world to the real economy.


walla said...

Tobinization of stock markets may divert liquidity to real-world investments.

hishamh said...

Fundamentally, what's being argued here is really market efficiency - does the market correctly value companies? If it does, than Malkiel's argument holds water. If it doesn't, then taxation makes some sense as it would reduce the potential for liquidity driven bubbles (and busts).

But the thrust of his argument is more along the lines of reducing market anomalies i.e. market efficiency is taken for granted.

His characterization of the US housing market is also strange - it sounds like he thinks the market was always correctly valued, it's just that valuations have come down (i.e. there was no housing bubble). Again, market efficiency is presumed.

umar said...

Every stock market transaction is taxed in both sides of the trade. When you buy a stock , you are paying stamp-duty and also when you sell. When you get dividend, there too you are taxed before you get your cheque. So if you made money, i mean capital gains there shouldn't be another tax.
the stockbroking industry pays analysts to write about companies so that clients are enticed to buy.No stock moves without any sponsors. There is no such thing as real intrinsic value reflected in the spot price of a share. Markets are manipulated by the players.
We should not comply with the government's wish of taxing us more. Reject GST outright. Don't promote that.