Senator Tom Harkin (D-Iowa) and Representative Peter DeFazio (D-Oregon) are set to propose a tax on financial transactions similar to what is being proposed in Europe (as if that lends them any support). It is being marketed by the folks behind it as very small, so small that Tom Harkin bets that "nobody would even feel it". Statements like that further convince me that he has absolutely zero knowledge of the financial world, not surprising given that he has had a total of 2 years of private sector experience (practicing law 37 years ago after he lost a Congressional election) in the last 49 years.
The tax they are proposing seems small at first glance, only 0.03% on trades of stocks and bonds but you don't have to dig too deep to see how this could have a huge impact. Most firms right now are paying a penny a share to trade a stock, sometimes less than half a penny but let's assume they pay a penny for illustrative purposes. If you have a $50 stock, in percentage terms, that commission amounts to 0.02%. So if you have to add the financial transactions tax on top of that, you are suddenly paying 0.05% in taxes plus commission for the trade, increasing your costs by 150%. Changes of that magnitude add up quickly especially if you do any short term trading. At a hedge fund, even if you have long term core positions it is easy to get up to 10,000% annual turnover (you might have short term trades after a stock got killed because of bad earnings or you might be taking index etf hedges on and off a few times a year). With turnover like that, the 0.03% tax ends up costing your investors an additional 3% on the year. And when you add that 3% to the 2% in management fees and then 2% in commissions you usually charge that means your stocks need to appreciate 7% before your investors start to even make any money!
Now let's not forget the high frequency trading shops. They do a massive number of trades at low cost to them trying to eek out pennies or fractions of pennies and accounted for 73% of all US equity trading volume in 2009. That would completely destroy that business model as it relies on almost zero transaction costs and all those PhD's will be out looking for work when there is none. While I am sure there are lots of people who want those firms to go out of business, there will be one major negative impact of this, the liquidity in the markets will dry up, especially if run of the mill funds also stop much of their short term trading. Less liquidity means that you will have to pay more to buy a stock and get less when you want to sell it, which will hurt all investors, both big and small. And to top it all off, with so much of the volume on the markets gone, this tax will raise a small fraction of what Harkin and DeFazio wanted to in the first place.
It really is mind boggling that anyone would even propose such a travisty which will have so many unintended consequences.