A proposed a tax on bank transactions will widen market spreads, reduce liquidity and ultimately reduce the returns that investors can earn, while not raise as much money as its proponents think. The "Robin Hood" tax is a bad idea, argues Tim Worstall.

The latest bright idea from parts of the political and cultural world is that we should raise $400 billion a year from the “Robin Hood Tax”. Apparently the financial system loses that much down the back of the sofa each year and it can be hoovered up to great effect on the nice things we could do with it: and no effects at all on anything so nasty as anyone actually having to feel the effects of paying for it.

Sadly, as everyone with an IQ higher than their shoe size knows, there really aren't such free lunches out there: there really is no great big pot of money we can raid.

The basic idea is the imposition of an extension of a Tobin Tax, a financial transactions tax, on every wholesale market transaction. Think Stamp Duty on steroids: it would be 0.05 per cent on every transaction that didn't involve an actual end consumer. This latter point is most important as it allows the proponents to try and convince the populace that it will be only the bankers and the pinstripe boys who will pay it. Alas, such an outcome will be untrue as they seem never to have even heard of the most important economic point about taxes: tax incidence. Those who hand over the cheque for tax are not necessarily those who bear the economic incidence of that tax. (This is a key point for wealth managers and their clients, a point I will discuss below).

Take, for example, that Stamp Duty tax on share transactions in London. We all know that there are many ways of getting around it, such as via contracts for difference (CFDs), options, futures and the like. But who is it that bears the actual burden of the £4 billion a year that is raised? Oxera, the consultancy, tells us that it is partly pension funds, the actual pensions that people receive after saving for 40 years, which carry it. Further, the effect of the tax is to depress share prices. This leads to higher capital raising costs, while a further extension of the tax incidence argument is that taxes which raise capital costs reduce the workers' wages. In fact, Joe Stiglitz, the Nobel Laureate, showed back in 1980 that tax incidence can lead to a burden on those who bear that burden of more than 100 per cent of the tax raised. As the Oxera research shows for Stamp Duty on shares, the effects in lost wages, pensions and output are greater than the tax raised.

But why should something this recondite be of interest to wealth managers? Sure, there are barking ideas coming from pressure groups every day and who, really, is interested in the arcana of the economics of taxation?

I think you should be interested. For the people who will bear the burden of this tax are your clients. That wealth that you carefully nurture, manage, aid in growing and generally caress with your investment skills: that's where the burden is going to end up.

The tax is set at 0.05 per cent on everything: currently buy/sell spreads on major currencies are around 2 basis points. Adding 5 bps as a tax will obviously widen that spread, this will reduce liquidity and thus the spread will widen further. The tax is not imposed upon the premium paid for a derivative like a future or option. It is imposed upon the nominal underlying value. (To view the original paper, see here.) To put it another way, an out of the money option you are using as a hedge becomes very expensive to purchase indeed. Of course, this tax will also reduce liquidity dramatically, making getting in or out of any position more difficult as well as more expensive.

In short, wealth management clients will be paying this tax in higher spreads, the tax itself and it'll shave some amount off investment returns as well.

Proponents of this tax, ignorant of issues such as tax incidence, do not realise this consequence. They really do have that childish belief that there is all that money down the back of the sofa. They really do seem to think that, as the original report suggests, you can tax the City to the tune of 3.6 per cent of GDP, when, as former Bank of England interest rate-setter Willem Buiter tells us, the City only makes up 4 per cent of UK GDP in total. With those sums it simply has to be true that someone else will be carrying the burden, not the City itself. (This argument has similar force when applied to Wall Street).

Why this is so difficult to understand escapes me. After all, it's those very folk who insist that the City is full of greedy, unscrupulous types who'd boil their grandmothers for glue. How can anyone believe that and also believe they'll happily cough up 90 per cent of everything they work for in tax? Which they won't of course: it'll be your clients that do.

Tim Worstall is a freelance writer and businessman. His blog can be viewed here.