10/25/2010 10:45 am ET | Updated May 25, 2011

The Wall Street "Trader Tax": Is Congress Targeting the Wrong Trades?

The title is neither subtle nor catchy, but it has bank lobbyists quivering.

The "Let Wall Street Pay for the Restoration of Main Street Act of 2009." Otherwise known as H.R. 4191, it is a bill you'll hear more about in 2010. The idea is to tax the speculative trading that accounts for an increasing, and some say alarming, share of Wall Street profits. We're talking about the rapid-fire, high volume, high leverage trades hedge funds use to create massive gains from minuscule asset price fluctuations.

The tax would claim a quarter percent (.25%) of every large stock purchase and 2 tenths of a percent (.02%) of every large derivatives purchase.

Economists are currently engaged in wonk-warfare over the trader tax. Some call the bill sound policy because it could generate $150 billion dollars for job creation and deficit reduction. Others declare the transaction tax is a sure fire recovery killer. That's an important debate to have, but if we assume some sort of securities transaction tax is fair (on the grounds US taxpayers deserve recompense for bailing out the banks), the tax should be apportioned so as to accomplish two goals: raise maximum revenue and de-incentivize systemically risky investment bets. The current bill fails on both accounts.

The trader tax reserves its biggest bite for stock trades, though traditional stocks were not the investment instruments that spawned the Great Recession. Derivatives, especially credit default swaps, were the lethal multipliers that turned a real estate bubble into a crippling credit freeze.

One can debate whether a trader tax is wise or unwise on the whole, but it seems spurious to suggest the bulk of the tax burden should fall on traditional equities like stocks. If the two goals of a transaction tax are curbing systemic risk and generating revenue, the tax incidence should fall more heavily on derivatives - not blue chips. Derivatives are inherently riskier and taxing them has far more potential to create revenue.

Not convinced? Consider the global value of stocks versus derivatives.

The value of all the world's stocks traded on all the global exchanges is estimated to be about $58 trillion. The value of all the derivatives contracts traded over-the-counter is estimated to be about $605 trillion. Put another way, derivatives trading accounts for a pool of possible tax revenue that is more than 10 times the size of pool of stock trades.

In the wake the decade-ending market collapse, some have begun calling derivatives nothing more than gambling. Indeed credit default swaps, interest rate contracts, and currency swaps look a lot like bets, since they are essentially complex wagers not legitimately backed by collateral. The banks, of course, claim derivatives are skillfully crafted contracts essential to hedging risk and making the US market the world's most liquid. Whether or not derivatives are a glorified form of gambling is a debate I'll save for another day. It's like arguing over whether poker is a game of skill or a game of chance. Surely it has elements of both. The critical point here is that derivatives are certainly more like gambling than investments in stock. The added risk is compounded by the fact that "too-big-to-fail" banks have sunk prodigious portions of their assets into these contracts.

The IRS taxes Las Vegas gambling winnings at a rate somewhere near 25%. The trader tax sponsored by Rep. Peter DeFazio, D-Oregon and Sen. Tom Harkin, D-Iowa would seek a tiny, tiny fraction of that. Before the tax emerges from committee, policy makers should recalibrate the percentages, increasing the burden on large derivatives and reducing the burden on stock trades - perhaps even exempting stocks altogether.

Even with these changes, the securities transaction tax faces serious hurdles. Though House Speaker Nancy Pelosi backs the bill, President Obama has yet to endorse it. For the trader tax to be successful, it will not only need White House approval, the administration will have to convince European and Asian nations to enact their own transaction taxes. Otherwise, Wall Street will simply avoid the tax by moving taxable trades offshore.

Authors of H.R. 4191 have tried to protect middle class investors from the tax on trades by exempting all transactions less than $100,000 and shielding all mutual funds and 401K retirement plans. Still the financial services lobby claims the costs to big investment firms will inevitably be passed down to retail investors. The potential of a trickle-down tax burden is a concern. However, history provides convincing evidence that concern should not be inflated.

To cope with the Great Depression in 1932, Congress enacted a trader tax worth more than 0.4% of every stock transaction. That is far higher than the tax being suggested by today's lawmakers.

The Depression-era tax remained in place until 1966, and during its life the value of the NYSE increased more than 800%. In the 17 years following the repeal of the trader tax, the value of the NYSE actually decreased by about 10%. This is not to say the tax was the cause of prosperity, nor the cause of decline. It is simply an illustration that market cycles may not be significantly affected by taxing trades.

On the other hand, there is near consensus that even a small tax on trades will discourage massive speculative investments in things like credit derivatives. Considering we now use phrases like "toxic assets" to describe those derivatives, that might not be such a bad thing.

Chris Glorioso is a television journalist in New York City who covers economics and politics for WPIX-TV.