The EU Financial Transaction Tax Debate

Levying financial transaction taxes is hardly a new idea. John Maynard Keynes proposed charging some form of tax for financial transactions in the early twentieth century, as did Nobel laureate James Tobin in the 1970s, whose eponymous tax encapsulates the idea of ‘throwing sand in the wheel’ to slow down excessive trading in the market.

In the current economic and political climate, as the world is still recovering from the 2008 financial crisis, it is easy to understand why the notion of FTTs is alluring in Europe. The continent was one of the hardest-hit regions during the Great Recession. To evaluate whether the policy of levying a 0.1% tax on stocks and bonds transactions, and a 0.01% tax on derivative trades is prudent, a deeper analysis of both benefits and costs is helpful.

The case in favor of an European Union (EU) Financial Transaction Tax (FTT) is supported by the arguments that the goals for this form of taxation are achievable and that the detrimental effects generally associated with these kind of taxes are minor when compared to the advantages.

Purposes of the EU Financial Transaction Tax

No standard FTT currently exists in the world. Different countries apply a variety of forms of financial transaction taxes to target widely dissimilar problems. The EU’s proposal of an FTT was set forth on 14^th February 2013. The main objectives listed in the proposal are:

1. Harmonizing current legislation of taxation of finances in the respective member countries of the European Union. Harmonization ensures there is no distortion of market competition between relevant actors and stakeholders in the financial sector.
2. Ensuring that financial institutions make a fair contribution to the financial crisis and leveling the playing field of the financial sector relative to other industries.
3. Creating economic disincentives for economically inefficient financial activities and transactions as a means to stabilize capital markets.

Exemption clauses that specify the sectors of the economy to which the FTT will not apply are drafted into the proposed plan. The exemptions are meant to preclude possible negative economic impacts from the financial transaction tax and to mitigate the detrimental effects. The sectors are:

1. Daily financial activities of citizens and businesses (e.g. loans, insurance, etc.)
2. Investment banking activities that aim to raise capital for productive ventures
3. The transactions carried out in the process of restructuring and refinancing with central banks of participating nations and the European Central Bank, with the European Financial Stability Facility and the European Stability Mechanism, and transactions with the European Union

The European Commission hopes to provide a more equitable field for the financial sector and other economic sectors in Europe with the enactment of the FTT proposal. One assumption underlying the EU FTT is that the financial industry contributed less to clean up efforts than others after the financial crisis of 2008. Another opinion is financial transactions are not taxed, yet played a huge role in destabilizing markets and ultimately creating the crisis still felt throughout Europe and the world. In addition, the FTT plan hopes to curb non-productive stock trading and increase the soundness of financial markets thereby reducing the frequency of crises.

Arguments for the Financial Transaction Tax

As with many economic policies, the decision on whether to implement the FTTs within the member states of the European Union has far-reaching and long-term consequences or benefits. Therefore, it is prudent to examine whether the goals the tax is aiming to achieve are actually attainable.

Goal #1: Harmonization of Relevant Legislation

Currently, legislation pertaining to taxation of financial transactions vary from country to country within Europe. Nations such as France, Belgium and the United Kingdom (whose FTT comes in the form of a stamp duty) already impose some form of levy on financial transactions within their respective borders. Others do not have any experience with such programs. Even within the countries where an FTT is in effect, the rates that trades in the derivatives market are taxed at or the products that are taxed also differ. For example, Finland currently imposes a 1.6% tax on the transfers of certain Finnish securities, which mainly consists of bonds, debt securities and derivatives, while Belgium charges taxes from 0.07% to 0.5% for various financial dealings including the distributions from shares of investment companies and accumulating shares of investment companies.

An EU-imposed transaction tax has the benefit of essentially leveling the playing field. The fragmentation resulting from various taxes imposed by each nation ultimately leads to unfairness and inefficiency in financial markets. Products or actions of companies may be subject to either double-taxation or non-double taxation. This variability not only distorts competition by exposing businesses to arbitrary imposition of extra costs due to their location, but also results in an exodus of capital from less favorable tax regions. For instance, corporate relocations occurred in Sweden when the Scandinavian country first set in place its FTT.

Market inefficiencies may occur because of misleading information sent by the price of the financial products. Typically, in an efficient market, the price of the goods on sale accurately reflects demand and supply. This element of pricing is especially important when it comes to instruments transacted in financial markets. In such markets, the price usually reveals the aggregate value of all known information, and is especially useful in helping investors evaluate the riskiness or the robustness of companies backing the financial instruments. The complexity of the varying levels of financial taxes imposed (or not imposed) may lead to inaccurate information as relayed by nominal values of the products. Lastly, the convoluted nature of differing tax laws make it difficult for companies to navigate their businesses. Precious resources are wasted on trying to obey the legislation of each country involved in each financial transaction.

A single standard FTT reduces competitive distortions that currently exist for companies based in different countries, creates a more information efficient marketplace, and generates a more coherent and business friendly environment regionally for the financial industry.

Goal #2: Financial Companies should Contribute Their Fair Share

The backlash against the financial industry in the wake of the financial tsunami of 2008 was unprecedented. One reason cited is that the actions and reckless trading of financial companies caused instability in financial markets. Yet the businesses that both directly and indirectly caused the crisis did not bear just compensatory burdens. Unlike transactions in many other sectors, financial transactions are often not taxed. The economic repercussions of the 2008 financial crisis were largely paid for by ordinary taxpayers (through bail outs, lost jobs and falling incomes), many of whom, probably never had dealings in sophisticated trading in the capital market. Therefore, the proposed tax acts as a sort of ‘insurance’, paid for by financial institutions, to recognize that every dollar made from a transaction has potentially broad consequences. The tax acts as a buffer against the future possibility of economic recessions occurring as a result of excessively risky financial activities. The funds raised are set aside to bail economies out of future financially induced predicaments or used to stabilize the market.

The revenues that could be raised from financial transaction taxes are in fact quite significant, despite the deceptively low tax rates.

Table 1: Revenues from financial transaction taxes in four countries (2001-2008)

Sources: HM Revenues and Customs, Revenue Irish Tax and Customs, Ministry of Finance (ROC), South Africa Revenue Services, IFS

Cited From: Financial Transaction Tax: Small is Beautiful

As seen from Table 1, the FTTs enacted in various countries have contributed impressive revenues to government purses. The European Commission estimates that after the implementation of the FTT, approximately €57 billion may be raised every year. Since modern financial transactions are carried out via computerized systems, it is extremely difficult to dodge taxes, making it all the more possible to realize the desired goal of insuring countries against another broad based economic catastrophe.

Goal #3: Discouraging Economically Unproductive Activities

The crux of economic debates concerning the FTT is whether the policy is able to discourage economically unproductive financial activities and restore the soundness of the financial system, if such a phenomenon exists in the first place.

Examining the financial markets, we get an idea of the range of (hyper)activity that exists. For example:

• By 2007, the total annual turnover rate for the main spot and derivatives markets was 70 times the world GDP.
• The transaction volume of interest rate securities was almost 100 times greater than the overall underlying investments.

What the data essentially show is that the virtual market for financial commodities has grown much faster than the market of underlying products. The problem arises, however, when short-term transactions, mostly speculative in nature, flood and then recede from markets to gain arbitrage profits. This excessive liquidity may be the cause of extremely volatile price fluctuations in various commodities. Arguably, these fluctuations take prices beyond the normal range of their equilibriums. Thus, such abnormal oscillations may trigger instability in the market, and consequently, the economy.

The imposition of the FTT may therefore, reduce the occurrence of excessive amounts of short-term trading, by making short-term investments (usually intraday) more expensive relative to long-term ones. Short-term trading is less preferable because this form of trading is associated with speculation, which often relies on price differences that show up in milliseconds. Long-term investment normally equates to the financing of real, productive ventures. The FTT precisely aims to stem short-term oriented and destabilizing activities and, at the same time make long-term investments comparatively attractive. In fact, according to EU estimates, based on the Swedish experience, the enactment of the FTT can effectively curtail high frequency trading, trading in highly leveraged derivatives, and possibly reduce derivative trades by nearly 90%. This is a significant change, as around 88% of transactions in global financial markets are centered on derivatives. Subsequently, the slowing effect of ‘throwing sand in the wheels’ of excessively speculative financial markets is attained.

Furthermore, the reduction of short-term oriented trading also brings about another benefit. As Paul Krugman notes, these speculative exchanges often cause distractions in the marketplace, which sidetracks investors from worthwhile ventures. Once short-term trading is reduced, information in the markets is more likely to be transparent to investors. Investment decisions are less likely to be misled by false signals.

Disadvantages of the FTT

Critics have arguments against the implementation of financial transaction taxes. Some objections raised are applicable to FTTs within national boundaries, for example; FTTs decrease the financial competitiveness of a country relative to its neighbors. Criticisms against the EU FTT focus on the effectiveness of the tax and the implications of the FTT on the capital-raising ability of European industry.

Criticism #1: FTTs are Ineffective

The effectiveness of the financial transaction tax is often questioned. The reason is that academic modeling and findings of research on the efficacy of FTTs often yield divergent, if not contradictory results. Advocates of the tax such as Summers and Summers (1989) and Schulmeister (2009) find nations that implement the FTT successfully reduce volatility of both long-term and short-term trading. On the other hand, Mannaro, Machesi and Setzu (2008) find FTTs potentially increase volatility through reducing liquidity. The review of empirical evidence produces the same inconclusive outcomes. Jones and Seguin (1997) and Liu and Zhu use the same methodology and apply their model to the U.S. and Japan, respectively. Yet the results are inconsistent, with one study exhibiting a decrease in the prices of stocks, and the other yielding the exact opposite conclusion.

Regarding the ambiguity of evidence presented, inconsistencies occur only within the context of hypothetical models or theories. As such, practical past experience should be examined more carefully. However, empirical studies also show divergent outcomes. We may infer from the research that the application of FTTs and their consequences are specific to the framework of the particular country in which they are implemented. Therefore, studies done specifically for the EU region should be prioritized before studies on other countries.

Criticism #2: Negative Impact of FTT on Raising Capital

Critics further argue that by imposing a tax on financial transactions, the cost of raising capital is much higher. Financial instruments such as stocks and bonds, are at their most basic, means by which companies raise capital to invest in useful ventures. By imposing an extra cost on these exchanges, the FTT discourages investment or reduces the ability of smaller corporations to fund prospective projects. An evaluation done by the European Commission confirms that the cost of capital does indeed increase along with a possible drop in economic growth of -0.3% in the 20-year period following the enactment of the policy.

While theoretically correct that capital costs more to raise with the imposition of the FTT, the effects may be mitigated by several measures. For example, by avoiding taxing primary financial products industries use to fund productive investments and only levying the tax on secondary financial products, the effect is a targeted tariff aimed at reducing the instability of the market without decreasing useful economic projects. The exclusion clauses set out in the original EU FTT proposal specifically excludes taxes when the transactions concerned are tied to productive activities. Such transactions commonly include the primary bond and stock markets. Furthermore, development funds and the daily financial activities of individual investors also are exempt from taxation, further reducing the detrimental effects of the FTT. Although there is a possibility of a drop in GDP, there also may be slight economic growth of 0.1% in the EU if revenues raised are spent efficiently on growth enhancing public investments. Even if there is a slight dip in economic growth, this outcome may be counter balanced by stable financial markets less prone to crashes. It may be better for the welfare of all to stabilize the financial system to ensure a 2008 type of crash does not occur again. Thus, the FTT may be a less costly way to improve the structural soundness of the EU’s financial sector.

While the FTT is not without flaws, the prospective benefits of stabilizing financial markets, guaranteeing insurance in case trades of financial firms go badly awry, and creating coherent and efficient markets may outweigh its negative consequences. The FTT should be more than a plan. It should make its way to practical application.

BY: PEI-YU WEI

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Photo: Courtesy of Flickr Creative Commons, Ahmad Nawawi