James Surowiecki sums up last week’s momentary free fall in the stock market:
But what does seem clear is that the plunge was exacerbated by the markets’ heavy reliance on computerized trades—both explicit “stop market” sell orders (that is, orders to sell a stock once it hit a certain price) and algorithmic trades that dictate buying and selling depending on different market factors.
and
I don’t think yesterday’s crash is evidence the market is irrational. It’s more that it’s a-rational: the computers aren’t panicking or herding. They’re just following simple rules. I think this is bad for the collective intelligence of the market, which really depends on diversity of thought and independence of action. But what happened yesterday isn’t, I think, quite the same as the crash of 1929 or the stock-market bubble of the late nineteen-nineties. It’s an example of the dangers of a-rationality (to coin a word) rather than irrationality.
Felix Salmon thinks this is an opportunity for a financial transaction tax
There’s a very sensible idea going around that a simple way to deal with nearly all of these problems, at a single stroke, would be to implement a tiny tax on financial transactions. Historically, people have complained that such a tax harms liquidity, which is true. But the fact is that it harms the bad kind of liquidity — the liquidity which dries up to zero just when you need it most. Liquidity, if it’s spread across multiple electronic exchanges and can disappear in a microsecond, does very little actual good, and in fact does harm during tail events like this. Let’s tax it, and raise some money for the public fisc at the same time as slowing down markets and making them think before doing a trade.
I think a financial transaction tax is a good idea. It is politically more doable at this time than any other time in the future. India already has one and it seems to do no harm to liquidity.
If you think about it, sales tax is a transaction tax. Why is it that there is no demur to a transaction tax on sales of goods (except on online commerce, which again is inexplicable), but financial transactions being taxed will bring about the end of capitalism?
6 am pacific 
There is no grudge on Sales Tax because the assessee is not the tax payer (i.e. it is not a direct tax, but is an indirect tax). Even though the dealer is the assessee, he is not paying the tax from his revenue, but collects the tax from the consumer for remittance to the exchequer. The tax paying consumer has little choice but to pay it up as part of the price if he has to buy stuff. However, a transaction tax is an eyesore because there is the incidence of income tax and capital gains tax that squarely covers every transaction. Yet another tax is certainly an overlap or a dubious double taxation on most occasions, that goes against the principle of tax equity.
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You can make the same argument about sales tax. That you first tax my income then you tax my consumption. Or that you first taxed the raw material, then the components and then the finished goods.
India seems to have no trouble with STT which is a transaction tax. Brazil taxes the flow of foreign capital into the country. I don't think there is really any good argument against a very small tax on financial transactions, other than changing the status quo is very difficult in the face of opposition from Wall Street and their lobbyists.
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Your metaphor "Or that you first taxed the raw material, then the components and then the finished goods" is not exactly fitting the context here.
Indirect taxes like central excise, sales tax (or even customs duty in case imported stuff) etc., paid on inputs (like raw materials and components) are allowed to be set off against similar taxes payable on finished goods by the Tax Department. So there is no tax cascade here.
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Basab,
You've missed the benefit to the investor that willingly pays STT. In India, if you trade in the public equity market after paying STT, you have the benefit of 100% exemption on long term capital gains (for shares, the holding period is just 1 year to qualify as LTCG) and a concessional rate on short term gains. So most investors, including promoters (a la Malvinder / Shivinder Singhs of Ranbaxy that sold out to Dai Ichi sankyo) that exit for good prefer to do it over the public market, suffer the negligible rate of STT thro block deal window than do it as a separate off-market transaction where they have to pay the average marginal rate of tax that is as high as 30% plus cess and surcharge. But the transaction tax that you seem to advocate is just another tax building up the tax pyramid than a tax that is as fair and legitimate as STT. If at all, it is the day traders that suffer from STT because they operate on wafer thin arbitrages.
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Whether the tax is paid willingly or unwillingly is immaterial. If there is a significant percentage of trading that attracts STT (which is what you are saying) and that does not diminish liquidity in the market in a harmful way then that makes my case. And many others by the way. I didn't think up the financial transaction tax. Here's one nobel laureate who proposed one such tax in 1972.http://bit.ly/d7QtbV
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Basab,
Thanks for the source. But that is Tobin Tax which is essentially a tax on short term currency speculation (without an underlying contract) – and is perfectly legitimate as it seeks to penalize frivolous forex bets that strains Foreign Exchange management system. What you've been suggesting is a wider "financial transaction tax" that will go to create a new tax to the already stretched list of levies, simply because central banks cannot manage FDI inflows.
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Moreover, a transaction tax is an indicator of incompetent fiscal management by the central bank of any nation. Why do they tax a transaction that essentially brings in FDI ? Any country that needs growth capital to finance its long term capex (say, infrastructure both hard and soft) should in fact relax restrictions and throw open all doors and windows for capital inflows. The only morons that plan to impose restrictions are those central bankers that are clueless how to channelize the funds for various national objectives and how to anticipate and provide for their disciplined exits. Now that's somebody not knowing how to do his job – but why slap the transaction with a freak tax that serves nothing but impede the free flow of funds into a country when it badly needs it and the tailwind is aiding it like never before? The basic principle of fundraising is to raise it when you get it, not necessarily when you need it – because when you really need it, it may not be around.
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Many would say that a tax on capital inflows (or outflows) acts as a dampener on "hot money". If the tax is small enough it will be insignificant to FDI which will stay in the country for many years.
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Basab,
Money has been, is and will always be "hot". It's only the policy makers that delude all money that comes in is for good and should never go back – blissfully ignoring the fact that for money to stay locked in, they have to draft timely, well rounded policies that augur well for the investee nation and the investors.
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Further, you have the stamp duty that is payable on every instrument that codifies a transaction. Even a supplemental agreement to a principal agreement will have to suffer this when value of the transaction is considered the basis of levy (ad valorem). Companies pay huge stamp duty even on a Debenture Trust Deed that just creates a "points-man" – a sort of one-throat-to-choke comfort for Debenture holders if and when the borrowers act up, even though this does not add to the value of a transaction. Mortgage is another excessive, when you have to pay stamp duty on a property that you are going to own and pay for over twenty / thirty years, but the tax is levied up front on the gross purchase price. To be meaningful, taxes will have to be just and equitable to the proportionate value that a given transaction directly confers to the parties and not policy avarice or an insurance for fiscal incompetence.
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STT is one of those ideas that sound amazingly simple, but that would have a stunningly huge impact – both positive and negative. it would prove to be a huge impediment to trading and will suck out the liquidity providers from the system.
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