By Joyce Beebe, Ph.D.
Fellow in Public Finance
The proliferation of retail trading in 2020 not only shone a spotlight on capital gains tax reporting, but also drew attention to a popular trading platform: Robinhood. In part one of this series, common tax compliance issues associated with using such platforms were discussed. However, the discussion about Robinhood and its retail traders would not be complete without mentioning the recent GameStop frenzy. This blog post considers what happened and what kind of tax policy proposals are being proposed as a result.
What Happened?
As recently as August 2020, the stock price of GameStop hovered around $5, but it surged to $347 in late January 2021 as a result of coordinated efforts by retail investors from the WallStreetBets subreddit. By March 2021, a large portion of the 800% price increase receded; however, the stock price is still much higher than anytime over the last five years before the incident.
Amid the price surge, Robinhood suspended the buying of certain stocks (including GameStop) on January 28, causing anger among retail traders. The platform later released a blog post stating that the suspension was in place to satisfy clearinghouse deposit requirements. Because it typically takes a few days to finalize a trade, a clearinghouse requires brokerage firms to provide collateral to protect themselves from losses in the case that a trade fails to conclude. Driven by the large number of buy orders and the price volatility, the clearinghouse-mandated deposit for Robinhood increased by ten-fold. The platform’s inability to meet that demand for the additional deposit forced it to pause trading. The restriction was partially lifted the following day; however, it limited the ability of retail investors to trade while institutional investors were not restricted.
This matter generated a series of reactions from stakeholders: numerous federal lawsuits were filed, congressional hearings took place, attorney generals in several states are currently considering investigations into Robinhood, and the U.S. Securities and Exchange Commission (SEC) contemplated whether or not there should be more transparency and regulations associated with online trading.
Although these platforms provide a channel through which more investors can approach the stock market, there is no consensus as to whether Robinhood and other low- or no-fee trading platforms ultimately benefit or hurt individual investors. On the one hand, cutting transaction costs provides broader access to the stock market, which has always been perceived as an investment vehicle out of reach for lower-income households. For instance, according to the Federal Reserve’s Survey of Consumer Finances, approximately 53% of U.S. households owned stocks in 2019. If filtered by net worth, the top 10% of households were over four times more likely to own stocks than the bottom 25% (94% ownership v. 20% ownership).
Robinhood’s premise is based on this idea — to democratize finance for all. The company claims that retail investors are generally sophisticated, and its technology not only disrupts the existing stock-investing mechanism, but it also offers all investors an equal chance to enter the market. For instance, during the congressional hearing in February, Robinhood’s CEO stated that it would be unfair to compare the investment returns of Robinhood’s customers with the returns from the S&P 500 Index Fund, because his platform provides a venue for anyone to invest, including those who may not have invested at all in the first place.
On the other hand, some believe a free-for-all approach presents a trap for the unwary. Concerns range from the platform’s “gamified” user interface (referring to the fact that the app is designed in a way that resembles the configuration of a video game) to the lack of detail explaining the investment risks involved. These critics believe that such factors led to the suicide of a twenty-year-old student in June 2020, who engaged in complicated options transactions and admitted in his final notes that he had “no clue” what he was doing.
Observers also stated that instead of providing admission to households who previously have no access to stock markets, the GameStop event demonstrated that the platforms promoted speculative trading instead of investing. In addition, young investors’ pursuit of short-term profits may not translate to long-term lifetime wealth.
Last December, Massachusetts filed a complaint against Robinhood’s “aggressive tactics to attract new, often inexperienced, investors,” and its “use of strategies such as gamification to encourage and entice continuous and repetitive use of its trading application,” among other issues. The allegations list a sample of 25 customers, each of whom executed an average of 15 to 92 trades per day on the platform over an extended period of time and none of whom had investment experience prior to trading with Robinhood.
Besides the Massachusetts’ lawsuit, Robinhood has been subject to multiple allegations and investigations, including cases from the SEC and the Financial Industry Regulatory Authority regarding technology-related service disruption, whether or not the platform ensures customer trades were executed at best prices, and if its disclosure of routing customer trades to specific places for execution in exchange for fees is sufficient. Regardless of the outcomes, these litigations and investigations will shape both public opinion and the platform’s conduct toward retail trading down the road.
Tax Policy Proposals
Although it remains to be seen whether or not major policy changes related to the financial market will emerge as a result of the Robinhood-GameStop controversy, tax-related proposals are already being contemplated. First, some lawmakers resurfaced the idea of a financial transaction tax (FTT). An FTT imposes a small levy on each financial transaction executed, essentially throwing “sand in the market’s gears” to curb short-term, excessive trading.
Over the last few decades, a large-scale FTT was debated several times but was never implemented. The most contentious points include the FTT’s revenue potential, the extent to which it curtails speculative trading and its effects on asset price volatility.
Supporters of an FTT argue that because the tax has a massive base (based on the value of financial transactions), even a very low tax rate has the potential of raising a significant amount of revenue. From a distributional perspective, FTT advocates often call it a “Robin Hood Tax” (ironically the namesake has nothing to do with the particular company involved). This is because the wealthy will bear most of the tax burden, and the tax revenue can be used on expenditures or programs that benefit lower-income households. The progressive nature of the tax also makes an FTT favorable from a political perspective.
Additionally, they claim an FTT would curtail speculative and high-frequency trading, which generates limited value to society. Evidence suggests that high-frequency trading has accounted for an increasingly larger portion of trades in recent years; however, the margin for each trade is usually quite small. Thus, a small FTT would be more than enough to stop most high-frequency trades.
Opponents dispute all the benefits mentioned. The debate about how much revenue an FTT can generate is unsettled. They believe the tax could be avoided if not designed properly, and taxpayers will look for ways to substitute nontaxable transactions for taxable ones. For instance, if the tax only includes stock transactions but not derivatives, many trades could be executed in the form of derivatives, but the exposure remains the same. However, properly defining the tax base for derivatives and ascertaining the taxable value of derivative transactions could be challenging due to the diverse nature of derivative contracts.
Critics also argue that an FTT may not be as progressive as claimed. Because many middle-class taxpayers own stocks through retirement savings plans and mutual funds, they may indirectly bear a substantial portion of the tax burden through these holdings.
Although there is no disagreement that an FTT would reduce trading volume, it is also true that the tax would reduce both productive and speculative trades. The relative split is unclear. To the extent the deterred trades are productive ones, taxpayers may be incentivized to avoid rebalancing and leave investment risks unhedged. Because the capital gains tax is triggered by sales, an FTT would exacerbate the “lock-in” effect, which obliges investors to hold assets longer than they normally would in the absence of an FTT. Some argue that this effect will be especially strong for investors who experience losses, because they still need to pay the FTT despite realizing a loss.
Furthermore, because an FTT increases transaction costs, it will no longer be worthwhile to trade on small price discrepancy, and stock prices will adjust less rapidly to reflect new information — a process called price discovery. In other words, an FTT may cause a less efficient price discovery process as it takes longer for new information to be priced into underlying assets.
Finally, through higher transaction costs and lower trading volume, an FTT would reduce speculative trading and the associated stock price volatility. However, the slower price discovery process would prolong investors’ reaction times before the prices adjust to reflect the fundamentals, which could lead to more price volatility. Empirical studies are also inconclusive as to whether an FTT increases or reduces asset price volatility.
Over the last few years, state-level FTT proposals emerged in New York, New Jersey and Illinois but faced significant objections from business communities. Exchanges such as the New York Stock Exchange (NYSE) and the NASDAQ have threatened to move to Texas or Florida if these proposals become law. As expected, financial service firms also strongly opposed the FTT and have been advocating against the tax.
As debates continue about the efficacy an FTT, a second tax policy proposal focuses on tax administration. Some lawmakers have leveraged the momentum from retail investors to advocate that Wall Street institutional investors should be subject to more regulations, including more tax scrutiny. Their proposal argues that the IRS should have extra funds and expand audits on high-income individuals and companies. Specifically, the bill proposes that individuals with an income over $1 million and corporations with assets that exceed $20 billion should have pre-specified annual audit rates that are much higher than the current levels, and these audit rates should increase with income.
Although this proposal does not have a direct connection with the GameStop incident, it reflects a heightened attention toward the $380 billion tax gap — the difference between taxes owed and those that are paid on time. Several recent studies show that a disproportional amount of the tax gap is due to high-income taxpayers, income sources that are not subject to withholding or information reporting and income generated from certain entity structures. Given mounting government deficits, it is increasingly likely that the tax gap will be addressed in the near future — through more IRS funds to improve the IT infrastructure, different withholding requirements, additional audits or a combination of these measures.