The economic consequences of the EU proposal for a financial transaction tax

THE ECONOMIC CONSEQUENCES
OF THE EU PROPOSAL FOR A
FINANCIAL TRANSACTION TAX

AVINASH PERSAUD

March 2012

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paid expertise, innovation, credibility
THE ECONOMIC and connectivity of our bankers not
CONSEQUENCES OF compete against a tax of one tenth
THE EU PROPOSAL of one percent? This is the largest
sector in the UK, are its fortunes really
FOR A FINANCIAL hanging on such a thin thread. One
TRANSACTION TAX wonders how much valued added our
financial sector can bring if it can be so
AVINASH PERSAUD1 threatened by so small a tax.

You would also be excused from
March 2012 thinking after hearing some of the
responses to the tax, that taxes are
an especially poisonous burden on
transactions, but the economic and
market impact of transaction taxes
are no greater than other transaction
1. INTRODUCTION costs such as trading commissions,
spreads, price-impact of trading,
There is no subject certain to raise the clearing, settlement, exchange fees
hackles of London bankers more than and administration costs which,
a financial transaction tax. In terms of just ten years ago, were collectively 1 Chairman, Intelligence
unleashing a torrent of abuse, it even greater than they are today in the Capital Limited, Emeritus
edges out the European Commission. equity markets, by the amount of the Professor of Gresham
No surprise then, at the strength of the proposed tax. College and Fellow,
reaction to the proposal in September London Business School.
The ideas presented
2011 by the European Commission for If tiny levies on trading activities would
in this report benefit
an EU wide, 0.1% tax on transactions cause such damage to the wider
from conversations and
carried out by financial intermediaries economy, investment and jobs, why collaboration with a
on equities and bonds, and a 0.01% do the fees and charges by banks and number of people too
tax on transactions in derivatives. funds on the same trading activities of many to name, but most
$100bn in the US and proportionately recently from Professors
The traditional response of all powerful more elsewhere, not come in for Stephany Griffth-Jones
industries under pressure, be it the even greater criticism?2 The impact and Rodney Schmidt.
tobacco industry in the 1970s or on the cost of capital of the alleged
2 Professor Kenneth
banking today, is to pursue a strategy manipulation by some bankers of the French documents that
of obfuscation. What draws me to this British Bankers Association’s LIBOR U.S. investors spent an
subject is not the “bashing bankers” reference rates, on which $375trn average of 0.67% of the
party, but the disproportionate, of transactions are priced every day, aggregate value of the
inconsistent and disingenuous was for many months greater than the market each year over
arguments used by my fellow bankers impact of a 0.1% transaction tax. But the period 1980-2006
against this proposal. The purpose we will not see the economic and job in searching for superior
of this paper is to provide greater costs to the wider economy of this returns includes trading
commissions as well
perspective to the issues of revenues, manipulation. It will be brushed off as
as the fees charged
avoidance and economic impact of a unfortunate, these things happen, and
by mutual funds and
financial transaction tax. it is good that it is now being put right. hedge funds in his cost
Despite the enormity of the tax-payer measure. See French, K.,
Listening to some bankers you would bailout and consequential impact on 2008, The cost of active
think that a 0.1% tax would usher the provision of public services, some investing, Journal of
in nuclear winter. Can the highly bankers rail against the economic Finance 63, 1537-157.

I NTE LLIG E NCE CAPITAL TH E ECONOM IC CON S EQU E NCE S OF TH E E U PROPOSAL FOR A FI NANCIAL TRAN SACTION TAX

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impact of tiny transaction taxes while largest economies on the continent,
reaping far greater sums from fees, Germany, France and Italy, the tax will
commissions and dealing profits, some likely raise £18bn and if levied in the
of which appear to be manipulated. The UK, would raise an additional £8.4bn.
alienation is impressive. To put these numbers into context,
if the UK Government were to raise
In their zeal to come up with examples £8.4bn through an FTT, it could,
of complicated off-shore, off-balance instead of tinkering with corporation
sheet transactions that could potentially tax over time, lower it in one swoop
evade this tax, some bankers appear to to 18% making it the lowest in the
have forgotten that they are a regulated OECD, bar Ireland, and as a result
activity and today, supervisors will make an impressive claim to promote
require capital to be put aside for real business. Alternatively, it could
activities that create risks. scrap the 50% higher income tax
bracket many times over, it could avoid
Perhaps most importantly of all, this all of the £8bn cuts to the education
financial crisis, even more than others, budget or more than double the UK’s
has taught us that while low transaction aid spending.
costs are generally good, it is bad
if they get so small that they are no To determine how much a transaction
longer any hindrance to activities, tax would raise, we need to know how
that through rapid turnover, give the much the demand for transactions
impression of great citadels of value in the taxing jurisdiction will fall as a
but turn out to be merely castles in consequence of the tax. If demand for
the sky. Moreover, the lower are transactions were inelastic to a rise
transaction costs, the greater are in transaction costs, then the tax take
gross exposures to net exposures and would merely be the product of the tax
this gap represents the vulnerability rate and the number of transactions.
of a financial system to shocks where This would be a mouth watering
everyone turns to the exit at the same £150bn around the G20 countries, but
time abandoning all of their losing such an outcome is unlikely.
trades. Small transaction costs will
therefore bring economic benefits as Critics of FTTs argue that transaction
well as genuine economic costs. We taxes will not raise significant
examine the net effect of these. sums because transactions are
highly sensitive to small changes in
transaction costs, which are already
2. HOW MUCH WOULD AN quite small. They say the bulk of
FTT RAISE IN THE EU AND financial transactions will either
IN THE UK? disappear, or bankers would find
ways of routing them elsewhere to
According to the EU Commission avoid paying taxes. The same critics
study, it is likely that a 0.1% Financial argue that this would have enormous
Transaction Tax (FTT) levied across the economic consequences. It does not
EU on equity and bond transactions entirely add up that transactions of
and a 0.01% tax on transactions in great economic value would be snuffed
derivatives will raise over £48bn. out by the tiniest rise in transaction
Levied across the nine countries that costs, but it is theoretically possible.
have announced their willingness to It is part of the obfuscation strategy of
proceed on their own, including the invoking the fear of the unknown. The


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Table 1: Selection of Existing Financial Transaction Taxes

FTT
Country Revenue FTT Rates for different assets
($bn)

Equity Bonds/Loans Options Futures Capital Levy

Hong Kong 2.79 10 basis points

0.25% on stock Local stamp duties 0.017% on 0.017% of
price; may apply premium; delivery price
0.025% on intraday 0.125% on strike
India 1.22 transactions; local
stamp taxes may
also apply

0.5% on value of 0.1-0.4% tax on capital
shares in formation
South Korea 6.08 corporations
or partnerships

0.25% of value; new
South Africa 1.41 share issues
excluded.

15 bps on domestic 6-12 bps on bond 1% on share issuance
Switzerland 2 shares; 30 bps on issuance in excess of CHF 1mn.
foreign shares.

30 basis points 10 basis points on 10-60 basis Up to 0.025
corporate bond points on basis points on
principal premiums. interest rate
Taiwan 3.3 futures; up to 6
basis points on
stock index and
other futures.

Stamp duty 0.5% on 50 bps on
secondary sales of 50 bps on strike delivery price
UK 5.86 shares and trusts price, if executed.
holding shares.

Total 22.66

Sources: IMF Working Paper ‘Taxing Financial Transactions: Issues and Evidence’ March 2011 and World Bank GDP
data, for all except Taiwan (source: Darvas and von Weiseacker (2010), ‘Financial Transaction Tax: Small is Beautiful’,
who quote figures from the Ministry of Finance). Data is for 2009 for Hong Kong and Taiwan, 2008 for India, South Africa
and the UK, and for 2007 for all other countries (South Korea and Switzerland).

problem with this position is that there already raise $23bn (£15.3bn)
is plenty of empirical evidence that small annually through long standing financial
transaction taxes, of the equivalent transaction taxes. Almost half of this
small increases in transaction costs, revenue is raised by the UK and
will not cause a collapse of markets or South Korea where both have a 0.5%
deviation to new ones. stamp duty on equities and despite
both having large and deep derivative
markets.
2.1 ACTUAL EXPERIENCE
WITH FTTs TODAY The table above ignores FTTs collected
in Brazil reported at £10bn in 20103.
Every day, significant sums are raised If this performance continues, existing
by financial transaction taxes, in FTTs across countries and instruments
dynamic economies, without bringing will be raising $37bn (£25.3bn) per
on armageddon. Seven countries annum. 3 See, Romano (2011).


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The table above also ignores countries that are raising significant
transaction taxes that are used to pay sums is that: (1) tax rates of 0.5% do
for specific, market related, regulatory not appear so high as to cause severe
functions. Except for how the funds distortions or substantial avoidance
are used, these “fees” have exactly the and evasion, though as we indicated
same economic and financial effects at the opening, we expect to see some
as transaction taxes and so the true avoidance; (2) there is no evidence
collection of securities transaction that we are at the wrong end of the
taxes and fees around the world Laffer curve and that at lower tax rates
annually is far higher than $37bn revenues would rise; (3) in practice,
(£25.3bn). tax rates levied on equity transactions
are higher than on bonds by a multiple
The US SEC, the securities regulator, of 3 or 5 to 1. It is interesting to note
is self-funded by a transaction tax that the ratio of equity to fixed-income
on the volume traded on exchanges. or foreign exchange fees in clearing
Many who rile against transaction houses also range from 5: 1 to 2: 1.
taxes and argue that slight taxes will
exact huge disrepair to markets are Most stamp duties have been on equity
often unfamiliar with this transactions instruments. In the past, taxing bonds
tax, set at 0.00257%, which raises a was a little more fraught than taxing
not-trifling $1bn (£667m) annually, equities, principally because bonds
to fund the SEC. This tax is called were traded over-the-counter, bonds
4 Under Section 31 “Section 31 fees” after section 31 of were bearer instruments and there
of the Securities the Securities Exchange Act of 19344 was no register of owners and short-
Exchange Act of but whatever it is called, the United dated bonds were a form of cash.
1934, self-regulatory States has a financial transaction tax. However, the universal trend towards
organizations (SROs)
These fees were raised 50% in 2010 trade-reporting, greater registered
-- such as the Financial
from 0.0017% - without the sky falling ownership under anti-terrorism finance
Industry Regulatory
Authority (FINRA)
in - and are likely to rise again given the and anti-money laundering rules and
and all of the national additional expenditure at the SEC. now central clearing and settlement,
securities exchanges makes the taxing of bonds more similar
(including the New York The table above does not show the to equities. That said, since bond
Stock Exchange and picture through time. Stamp taxes are markets have lower volatilities, lower
the American Stock old and common5. Before the financial elasticities and lower trading spreads it
Exchange) - must pay crisis when the sector convinced us could be argued for a lower rate than is
transaction fees to the that nothing should stand in the way of appropriate for equities rather than the
SEC based on the
more trading, some of these taxes were same rate. The EU Commission already
volume of securities that
taken off or moderated as their yield accept the principal of differentiating
are sold on their markets.
These fees recover the
grew so large as was the case with the the taxes for different securities in
costs incurred by the US securities tax. More recently, some regards to derivatives.
government, including have been reintroduced. One of the
the SEC, for supervising essential lessons from the history of
and regulating the these taxes, is that this is a policy that 2.2 ESTIMATING
securities markets and can be tried and, if it proves too costly, THE IMPACT OF THE
securities professionals. reversed relatively easily and quickly. PROPOSED TAX
5 The first stamp tax
The US Section 31 fees have been
was first devised in the lowered 9 times and raised 7 times The impact of a transaction tax on the
Netherlands in 1624 since 1934 without stir. demand for a transaction is the same
after a public competition as any other transaction cost, such
to find a new form of tax. The “revealed preference” from those as clearing and settlement, trading


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commissions, dealers spreads, price during the transaction there would be
impact of trading, fund management dealer costs and afterwards clearing
fees etc. Indeed, the economic and settlement costs, custody and
impact of the State raising £8.4n reporting costs. The decision to buy
from transactions is the same as the BP shares is based on an investment
economic impact of the banks, brokers, view that investors in the fund would
mutual funds and hedge funds raising make a return after all of these
$8.4bn of revenues from trading with costs have been taken into account.
end-users6. Yet the same banks and Recently, pension fund trustees have
fund managers that complain loudest complained that all of the costs fund
about financial transaction taxes hurting managers deduct over and above fund
the market, make considerably more management fees, are very substantial.
from transacting with their clients. If fund management fees are also
added to these the client’s costs total
The economic impact of a transaction transaction costs are in excess of
tax is also the same as if dealing 0.67%8 per annum. Measured against
spreads (the difference between the total transaction costs, the proposed
purchasing price and selling price of 0.1%, FTT is less than 10% of total
an instrument) were to widen by the transaction costs.
equivalent amount, or were to return
to a level greater than current levels by Studies of dealing-related costs,
the amount of the tax. Spreads were excluding research, administrative
0.1% greater than current levels in the and managers fees, but including
most liquid markets as recently as ten commissions, spreads, clearing and
years ago – see the progress of spread settlement costs indicate that the
decline in the US market in table 2. elasticities of demand for equities of
a rise in transaction costs are in the
In order to estimate revenues, a number region of 0.25 to 1.65, averaging
of studies have tried to determine around 0.6. This implies that a 1% rise
the price elasticities for one country in transaction costs (including taxes)
imposing a transaction tax7. An early will lead to a 0.6% fall in volume. Given
issue of contention was what we that we are not including all transaction
mean by transaction costs. Critics costs this is likely to be an over-
like to compare financial transaction estimate of the elasticity.
taxes with trading spreads or dealer
commissions which are now quite These point estimates of elasticities
small - one or two basis points - for the are also likely to be an over-estimate
markets with greatest turnover, though of the effect of very modest rises in
they were higher by the amount of transaction costs. Below a certain size
the proposed FTT just ten years ago, of transaction costs, the level of general
see table 2. However, as Professor uncertainties, including the likelihood
Kenneth French (2008) observed, of the asset price changing during the 6 French (2008) – see
these costs are a small fraction of transaction period, means that there footnote 2.
the total costs behind a transaction. comes a point where the gains from
If we were to read in the newspapers a further reduction in administrative 7 For a recent review
that a mutual fund buy shares in BP, transaction costs bring little benefit. It is of the results of these
studies, see McCulloch
before this transaction was authorized noteworthy that spreads have not really
and Pacillo (2010).
by an investment committee of paid moved over the past ten years despite
professionals, there would have been advances in trading technologies. The 8 French (2008) – see
research and administrative costs, investment literature generally shows footnote 2.


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Table 2: Dealing spreads for small and large equity trades in the US
equity market (where spreads are smaller than in other markets).

that where nothing else changes, 3. WHY CRITICS ARE
small changes in the short-term cost of WRONG THAT THE UK
capital, like the ones we are discussing WOULD LOSE UNDUE
9 For an interesting here, have little impact on investment BUSINESS OVERSEAS
study on the elasticities demand9.
of investment in general Capturing the tax paid by residents
to transaction taxes The revealed preference across and non-residents on buying or selling
where the potential for
countries with existing FTTs and the instruments issued by issuers resident
substitution is high,
empirical analysis suggests that the in the country will be easy with very
see “Taxes, the Cost of
Capital, and Investment:
a 0.1% tax would have a modest limited opportunity for avoidance
A Comparison of Canada impact on demand, ranging from 5% or evasion. This would represent
and the United States.” to 15% in different markets, and would over 50% of tax revenues in most
Kenneth J. McKenzie and therefore, despite its low level, yield jurisdictions.
Aileen J. Thompson, April signiﬁcant sums. Based on a survey of
1997. this evidence and further observations Stamp taxes are paid by anyone
above, the EU Commission’s estimate - residents and non-residents,
10 Stamp taxes have a
long tradition in many
that €57bn per annum could be raised corporates or individuals - on the
countries including if all EU countries adopted a 0.1% transfer of ownership of a resident
Malaysia, Netherlands, securities tax for equities and bonds security. Where “stamp taxes” are
Ireland, Israel, UK and and a smaller 0.01% tax for derivatives due10, a non-taxed and therefore non-
the US. appears highly reasonable. stamped ﬁnancial transaction cannot


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be legally enforced, and there can be French bank in New York, to buy a UK
no registered change of ownership to security will still have to pay the tax
local or foreign buyers until taxes are because otherwise he will not receive
paid to, and stamped by the authorities. legal title to the security and could not
Non-enforceability of contract is a very receive any dividends, rights and claims
high consequence of non-compliance and his contract to buy the shares
with the stamp duty. It is particularly would be unenforceable in the relevant
so where registered owners of assets jurisdiction. This is too high a risk for
are due to receive certain benefits investors to take – no pension fund
and rights like voting at shareholder trustee would take such a risk. Taxing
meetings, dividends, interest coupons, by residence of issuer is therefore far
rights issues, buy-outs etc. These more effective with very limited scope
stamp taxes are collected at settlement for evasion which is why stamp duties
where change in registered ownership on financial transactions already raise
takes place. (They are a levy on over USD$23bn (£15.3bn) per year.
the transfer of legal ownership, not And, critically, it is so hard to avoid that
on transactions per se and so the a very high proportion of those paying
compliance of brokers around the these taxes are in fact non-resident of
world, in New York or Beijing is not the country imposing the tax – in the
necessary). case of the UK it is estimated that 40%
of the Stamp Duty Reserve Tax on UK
In order for the authorities to tax a equities is paid by non-UK-residents.
transfer of ownership, the register
of owners has to be held in their The 0.5% Swedish financial transaction
jurisdiction and hence the issuer of tax that was introduced in January
certificates of ownership (shares) 1984, on the purchase or sale of an
would need to be locally incorporated. equity security by a Swedish resident,
It is possible for companies to jump collected through Swedish brokers,
ship and incorporate somewhere else, was fatally flawed as it was not a
but the same argument could apply to stamp tax on the transfer of ownership,
changes in corporation tax and much but was levied on residents buying
larger differences in corporation tax a local share and collected by local
between jurisdictions have proven brokers. It could be avoided by a
sustainable. Within the OECD, resident buying overseas an untaxed
corporation tax rates vary from 12.5% foreign security where the security was
to 40% and even when the extremes a holding of a share local to the tax
of Japan and Ireland are removed there payer. The tax was relatively high and
are still differences of 5% or more that there were easy, untaxed, substitutes
prove sustainable despite the footloose for Swedish securities. Avoiding the
nature of enterprise today. Moreover, tax was a high-return, low risk venture
this tax has an indirect impact on the and so many Swedes routed their
cost of capital for companies as it purchases through London entities
is paid directly by resident and non- that presented themselves as overseas
resident investors in the secondary buyers of Swedish stocks. Swedish
markets whose tax payment is highly brokers felt particularly hard done by
variable depending on the frequency of as their business had merely switched
trading. to foreign brokers. Despite raising over
$1bn per year, the Swedes scrapped
Stamp duties are nigh on impossible this tax because of the iniquity that only
to avoid. A Chinese investor, using a half were paying it.


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There are two ways to stem this leak. 3.1 DERIVATIVES,
First, if it were a “stamp tax”, then the CONTRACTS FOR
tax resident masquerading as a foreign DIFFERENCES AND
resident, would still be liable for the LONDON
tax when buying the local share. This
would have substantially plugged It is often argued that if there were a
the hole in the case of Sweden. But tax on transacting financial instruments,
secondly, residents could be further market participants would switch to the
liable for the tax on the purchase or derivatives market where the tax could
sale of any security and therefore even not be levied because derivatives are
buying foreign securities, irrespective invariably not issued by the issuer of
of whether their underlying holdings the underlying security. The footloose
were local securities or not, would not nature of derivatives would then lead
be a way of avoiding the tax. This would the largely London-based derivative
reduce the incidence of avoidance market to decamp to another untaxing
significantly and would also capture jurisdiction, carrying jobs and GDP. The
foreign issued derivative instruments threat of decamping is often used by
on local stocks. There will still be those companies and industries to lever less
who try to evade the tax by establishing taxes and regulation but as this last
themselves up overseas, which they financial crisis has taught us the long-
can also do to avoid many other taxes term, wider, consequences of giving in
where evasion exists but not enough to such threats are likely to outweigh
to undermine income tax, corporation the benefits.
tax and capital gains taxes. But this is
not only illegal, it is also costly. Setting From a tax raising perspective, if the
up, illegal, parallel structures to trade taxes are due if either the instrument or
overseas instruments and then to find the investor is resident, then investors
illegal conduits to return funds when resident in London would still pay the
required, is not costless or risk-free. tax whether the market had stayed in
It is not a cost or risk that institutional London or moved to Timbuktoo. There
investors, regulated or publicly listed would be a loss of revenue from non-
entities - the bulk of investors in stocks residents if the market went elsewhere
and bonds - could carry. Even without and perhaps jobs and GDP. But would
an FTT, internal revenue agencies in the market decamp in response to a
the US, UK, Germany, France, Spain one hundredth of one percent tax?
and elsewhere are cracking down on Are the benefits of a concentration of
residents who hold assets abroad and liquidity, expertise, connectivity and an
do not declare any tax liabilities they overall favourable fiscal environment
may have. Moreover, new regulatory in London not worth that? If not, one
requirements we spoke of before, in wonders what is the benefit of having
particular for mandatory reporting of this business? And if the people and
all trades, on or off exchanges, make institutions stayed, but trades were
evasion through non-reporting harder merely booked somewhere else, then
than before. the loss of jobs and GDP would be
slight and regulators would consider
the operation risky if it created on-shore
liabilities from off-shore activity, and
would impose a capital requirement
on the activity, eroding the benefit of
avoiding the tax. It is therefore unlikely


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that the derivatives market would be unenforceable if the contract were
execute their threat to decamp. We will not stamped. It is important to note that
return to the issue of jobs and GDP even if one investor were prepared to
later. take all of the risks – for the sake of
saving a small fraction of one percent
- they would then have to find another,
3.2 COMPLEX DERIVATIVES equally prepared to do so, so as to
WOULD BE NO PLACE TO exit from their investment with a return.
HIDE FROM AN FTT Non-compliance would be a high-risk
venture.
It should be noted that instruments
which are not-taxed and are therefore
not legally enforced, could not be 3.3 IMPLEMENTATION
considered eligible for central clearing ISSUES
by a clearing house. This is of crucial
importance today and represents Given all that we have discussed
one of the ways in which financial above, it would be important for the
transaction taxes are far more feasible Financial Transaction Tax to be levied in
than before, even for derivative two complimentary, but separate ways,
instruments. One of the responses to first, as a tax on the transfer of legal
the financial crisis by the G20 and the ownership of locally issued securities.
Financial Stability Board is a regulatory No special mechanisms are needed to
requirement that all exchange traded implement this. The revenue authorities
instruments, including equities, bonds, can establish automatic electronic
derivatives and all vanilla over-the- stamping of certificates where there are
counter transactions such as credit automatic electronic payment schemes
default swaps, must be centrally and these are likely to be established
cleared. Instruments held by financial by payment settlement agents. This
institutions that are not centrally is already in place in many countries.
cleared will incur a capital adequacy The UK SDRT is mechanically paid to
requirement11 - that could far exceed the UK tax authorities by the investor,
suggested levels of transaction taxes. through settlement agencies connected 11 The Communique,
to the clearinghouses – which for a issued after the G20
meeting in Pittsburgh in
The consequences therefore of holding long-time were physically in Belgium.
September 2009, states:
non-taxed instruments, in terms of loss
“all standardized OTC
of legal certainty, higher counter-party Secondly, an FTT on foreign securities, derivatives contracts
risk, loss of gains from netting in a at the same rate as for local securities should be traded on
clearing house, and the cost of higher would be required to be paid by exchanges or electronic
capital adequacy requirements for residents in their annual tax declaration trading platforms,
holding them, are quite substantial. It is of investment activity. In countries that where appropriate,
estimated that over 70% of OTC credit have capital gains tax on security sales and cleared through
derivatives will be centrally cleared and the information required to calculate central counterparties
those that are not, are highly bespoke the transaction tax is already declared. by end-2012 at
the latest”…“OTC
complex contracts that the clearers Additionally, there is often a withholding
derivatives contracts
don’t want to clear because they tax on dividends to foreign residents
should be reported to
are so specialized and are therefore and so there is a substantial incentive trade repositories,” and
unlikely to be frequently traded. Of – far greater than the tax – to declare “Non-centrally cleared
course even the non-centrally cleared the transaction in order to receive a tax contracts should be
instruments would be subject to the rebate from the foreign tax authorities. subject to higher capital
tax and the derivative contract would New reporting requirements on all requirements.”


11

transactions in G20 countries and new the model output, such as the inability
scrutiny on assets in other locations will of the model to tackle differences in the
by itself make avoidance and evasion incidence of the transaction tax caused
costly and risky. by the different holding periods of the
investor - the average pension fund
The combination of a Stamp Duty that turns over only half of its portfolio every
is hard to avoid on local securities, and two years and so the increased cost of
a wider FTT on international securities long-term capital may be considered to
that may be theoretically easier to be considerably lower than if primary
evade through non-reporting, but issues were purchased by high-
only at the expense of withholding tax frequency traders - these mitigating
rebates, and complex, costly, illegal factors push the impact on GDP to
and financially inefficient ring fencing of -0.1% or less. Mechanically converting
local and resident portfolios, would be this to UK jobs in the same manner
more effective than either a Stamp Duty as before would produce a figure of
alone or a wider FTT alone. In this case 29,000 or less, but not 500,000.
the belt benefits from the braces.
But even this analysis is dangerously
incomplete on a number of grounds.
4. THE IMPACT OF AN FTT First it doesn’t assume fiscal neutrality:
ON GDP12 it assumes we take the revenues, dig a
12 This section borrows hole in the ground and put them there.
heavily from my work The EU Commission tried to estimate What would happen to the overall cost
with Professor Stephany the impact on GDP of a 0.1% FTT of capital if revenues from the FTT were
Griffith-Jones who levied across the EU on equity and used to lower corporation tax on profits
contributed by far bond transactions and a 0.01% tax by 10 percentage points? Given that
the greater portion of
on transactions in derivatives. The in the UK in particular, that 40% of
insight, analysis and
economic model they used converted the existing stamp duty is paid by non-
interpretation.
the FTT into an increase cost of capital residents, it is likely that if the revenues
13 Based on most recent and measured the GDP impact of that of an FTT were used to reduce the
EC and BIS data, the higher cost of capital. Prior to adjusting taxes paid on profits by residents,
sources of financing of for any mitigating elements of using this that the net effect could be to lower
companies are assumed model, the initial output of the model the cost of capital in the UK, thereby
by the Commission to be
was a potential GDP loss of 1.76%. boosting employment. It is certainly the
primary equity issuance
Critics of the FTT have latched on to case that many of the countries that
(10%), retained earnings
(55%), and debt (35%).
this number and equated it in the UK do have FTTs have not been growth
The share of debt with a loss of approximately 1.76% laggards: South Korea, Hong Kong,
securities in total debt of of the workforce or 500,000. This is India, Brazil, Taiwan, South Africa and
nonfinancial corporations a highly disingenuous conclusion, as Switzerland.
could be estimated at the Commission later moderated this
about 15% (or about figure to -0.5% to take into account a
5% of total financing). number of mitigating factors and more 4.1 IMPROVING
As we discussed above, recently, having adjusted for the reality FINANCIAL STABILITY
this mitigating factor is
that UK and other European companies & RESILIENCE
now incorporated into
are not generally funded through the
the second version of the
model, see again Lendvai
primary issuance of new equity, they If the FTT reduces certain financial
and Raciborki, op cit. have further revised down this figure to market distortions and thus systemic
This implies the growth -0.2%13. risk, it can – by reducing the risk of
effects of FTT are now future crises - lead to significantly
down to -0.2% of GDP. Considering other mitigating factors to higher long-term growth. There is here


12

a parallel with the argument, made, for as well as buyers in crashes. Finding
example, in the paper by Miles (2011), value is a long-term endeavour and
from the Bank of England’s Monetary can lead to many short-term losses.
Policy Committee, arguing for higher Consequently the other kind of traders
capital adequacy requirements for are “noise traders” that focus on trends.
banks and modeling that part of their Rather than stubbornly selling into a
impact as positive for growth as it boom, they will buy and benefit in the
reduces systemic risk and therefore short-term. But the more buying there
the probability of future crises. Crises is in a boom the longer the boom and
clearly always lead to periods of greater the fall. The more noise traders
substantially lower or more often, there are, Blanchard and Summers
significantly negative growth (for eight showed, the more likely we will get
centuries of empirical evidence on the misalignments in markets (up and
link between crises and lower growth, down) and consequently, the more
see Reinhart and Rogoff, for a recent savage are the adjustments back.
assessment of the negative effects
of the European crisis on UK median “High Frequency Traders” and “Noise”
income, see IFS, 2011, and below). traders have much in common. Both
hope to get out before the crash gets
We are clearly not arguing that on its scary and are focused on (very) short-
own, the FTT would reduce the risk term returns. Higher transaction costs
of crises, as prudent macroeconomic limits the ability to make high but very
policies, and effective financial short-term returns and will limit the
regulation as well as supervision, amount of “noise trading”. By doing so
have the major role to play in crisis the FTT would make a contribution to
prevention, but it may have a role to the reduction of severe misalignments
play. and hence the probability of violent
adjustments. Relatedly, but separately,
in financial crises “gross” exposures
4.2 BOOMS TO CRASHES matter more than the net as scared
investors run for the exit, and financial
It is tempting to consider financial transaction taxes will reduce the gap
crashes as relatively random events of between the two and reduce financial
piracy, but in reality financial crashes vulnerability.
invariably follow financial booms and
the bigger the boom, the deeper the The growth costs of crises are massive.
crash. One of the big issues in crisis For example, Reinhart (2009) estimates
prevention, therefore, is limiting the that, from peak to trough, the average
size of booms. In their seminal work fall in per capita GDP, as a result of
in this area, Olivier Blanchard and major financial crises, was 9%. The
Larry Summers, showed that booms Institute of Fiscal Studies (2011)
can get large and become self- has recently estimated that for the
sustaining if there is a pre-ponderence UK, when comparing the real median
of “noise traders” in the market. They income household income in 2009-
postulated that there were broadly 2010 with 2012-2013, the decline
two kinds of traders, one that they will be 7.4%. Of course for European
called “fundamental traders” who seek countries directly hit by the sovereign
value and would tend to be sellers debt crisis, like Greece, the decline of
during booms, when financial prices GDP and incomes will be far higher,
rise above historical metrics of value, though they are unlikely to approach


13

the 20% declines witnessed during the During calm times, when markets are
Asian financial crisis. already liquid, high-frequency traders
are contrarian and therefore support
It is possible that all an FTT will do liquidity, but this is when liquidity
is reduce the amplitude of booms is already plentiful. During times of
and crashes, but the less severe the crisis, they try to run ahead of the
misalignments and less violent the trend, draining liquidity just when it is
adjustments, will reduce collateral needed most, as we saw with the Flash
damage that will contain risk and Crash on 6 May 2010. If a transaction
uncertainty, boosting productive tax limits high frequency trading it
potential. will provide a bonus in improving
systemic resilience, bringing GDP and
Should the FTT for example decrease investment benefits15.
the probability of crises by a mere
5%, (which is a very low assumption),
and the cost of lower GDP growth 5. WHO PAYS FOR
in the long term due to crises were THIS STABILITY?
around 7 %, (consistent with the above PENSIONERS?
estimates), then the positive impact of
the FTT on the level of GDP, due to Commentators often argue that
crisis avoidance, could be a +0.35% customers will ultimately pay the tax,
of GDP. In that case, the net effect of which is likely to be the case in a highly
the FTT on the level of GDP would be competitive market where firms are
+0.25 % (if we combine the negative on the edge of breaking even. This is
14 One of the impact estimated by the Commission not a good description of the banking
observations of Adair model of -0.1%, with the positive one industry. In the years outside of banking
Turner, Chairman of the
just estimated of +0.35%). These are crashes returns to capital and labour
FSA, shared by others,
not big numbers but they do imply are superior to other industries and
is that the collapse
of transaction costs
a positive impact on employment of so it is possible for part of this tax to
towards zero facilitated 75,000 in the UK alone. be paid by the industry through lower
the creation of huge profits. The top 1,000 banks in the
derivative markets world reported collective profits of
balancing on relatively 4.3 FINANCIAL MARKET £540bn in 2008, before collapsing
small underlying markets, LIQUIDITY in 2009 and rebounding to £267bn.
which made financial To preserve market share banks may
systems more vulnerable Creating disincentives for short-term well decide to swallow a tax that
in a crisis. The optimal
speculation (as opposed to long- represents in a good year less than
level of transaction taxes
term investment) is considered an 10% of profits. But what of the portion
may be low, but it is not
zero.
attractive feature by many and was paid by consumers? Not all consumers
one of the arguments used originally of financial products will pay equally:
15 This destabilizing by John Maynard Keynes and James long-term investors like pension funds
behaviour is well Tobin in favour of transaction taxes14. and insurance companies will pay least
described in “Positive Others suggest this might undermine and short-term speculators like hedge
feedback investment
liquidity, but this argument is specious. funds or High Frequency Traders (HFT)
strategies and
While high turnover is one symptom will pay most. Given that in general,
destabilizing rational
speculation”, J. Bradford
of liquidity, financial market liquidity is regulatory agencies only allow hedge
de Long, A. Shleifer, about diversity: when you want to sell, funds to market to high net worth
L. H.Summers and R. someone wants to buy because they individuals, this tax will be progressive
Waldman, Journal of have a different valuation or investment with banking and hedge fund profits
Finance, June 1990. goal or strategy. tapped more than pensions.


14

Table 3: Implied holding periods from stamp duty receipts

Tax year Value of share purchases as Implied average holding
% of average value of UK period of companies
listed companies (months)
2001-2 36 33
2002-3 42 29
2003-4 40 30
2004-5 36 33
2005-6 30 40
2006-7 26 46
2007-8 26 46
2008-9 35 34
2009-10 27 44

Source: UK National Statistics, London Stock Exchange and IMA calculations

According to the data above, the crashes occur on average every 10
average UK pension fund holds a stock years. We point out above that financial
in its portfolio for 44 months or 3.5 crashes have many proximate causes.
years. If we assume then that there is However, roughly, if a transaction tax
a 0.1% transaction tax for buying and of 0.1% reduced the role of “noise
selling and every 3.5 years a pension traders” which reduced the size of
fund has bought and sold 50% of its misalignments in markets, which
portfolio, the average pensions fund reduced the incidence of financial
would pay transaction taxes equivalent crashes by just 5%, and this reduced 16 The rough calculation
to 0.03%16. This compares with annual risk and uncertainty boosted returns, is (0.001 (tax) x 2 (both
management and transaction costs of then the increased expected return of sides of the transaction)
pension fund assets of over 0.69%, pension funds would be higher than the x 0.5 (half the portfolio) x
which are twenty three times the 0.03% cost of the tax18. 0.3 (in one year and not
incidence of the tax. 3.5) x 100) per year.
The actual equation would have to take 17 The rough calculation
A High Frequency Trader turning over into account whether the reduction in is (0.001 (tax) x 2 (both
its entire portfolio in a day, would pay the risk of a financial crash increased sides of the transaction)
transaction taxes of 50% per year, the long-term return of assets or just x 1.0 (all of the portfolio)
or 1666 times more than an average altered the return profile over time. x 250 (every day) per
pension fund17. Of course, what is more It is likely that reduced volatility and year x 100).
likely to happen, however, is that high- therefore uncertainty reduces the
18 The rough calculation
frequency trading falls off dramatically. need for precautionary behavior and is (0.33 (loss given a
The cost of financial crashes is as increases the sustainable rate of return, crash) x 0.05 (reduced
heavy for investors as it is for most but the essential point is that the cost likelihood of a crash) x
others. Stock value declines in crashes of the tax will fall least on pension 0.1 (every ten years) >
are in the region of 33% to 50% and funds, would be marginal compared 0.001 x 2 x 0.5 x 0.5).


15

with returns and if the tax brought but to make it more fit for purpose,
benefits in terms of financial stability more sustainable and more supportive
these benefits are likely to offset these to the economy. Financial history is
slight costs, boosting pension pots littered with financial crises. The only
along the way. safe conclusion one can draw from this
history is that the financial sector is not
very good at assessing risk and returns.
6. CONCLUSION This is not an argument for Statism -
Governments are often no better. In
Imposing a 0.1% financial transaction booms, financial activity appears to be
tax on equity and bond and a 0.01% highly productive and profitable, while
tax on derivative transactions will in crashes, much past financial activity
raise approximately £9bn in the UK turns out to have been a mirage. In
and £48bn if extended across the 2007, the cumulative return of financials
EU. Turnover will fall in response to in the UK, US and euro area from
the tax. Turnover of high-frequency 2000 was 160%. Just two years later,
traders will fall most, but this is likely the cumulative return from 2000 was
to be a good thing from a financial -25%19.
stability perspective. The total and
long-term economic impact of such a These mirages are more easily created
tax is likely to be positive, once the tax and harder to see through, in a world
re-shifts the market, a little, towards in which transaction costs are tiny.
longer-term valuations and away, a Huge edifices of activity and apparent
little, from the dominance of short-term assets can be built up while spinning
trading. GDP and employment in the rapidly on margins of activity. Before
UK could be boosted by 0.25% or the mirages melt, enormous returns
the equivalent of 75,000 new jobs in to capital and labour were made on
the rest of the economy. Turnover of bets that will fail and then tax payers
derivative transactions would probably will have to pick up the pieces to
be most affected amongst securities, ensure the payments system survived:
but it is doubtful that this would mean privatized gains and socialized losses.
a shift in jobs from London, more a
potential shift in the location of where Net of the bail out, the financial sector’s
trades are booked, clipping some of once superior returns have proven to
the potential tax revenues, but not be a mirage and no better than other
by much. If the tax is levied both as a sectors, which is why other countries
stamp duty on instruments issued in the with less emphasis on banking have
UK or anywhere else the tax is levied, out-performed the UK. This is another
and also on investors buying non-UK inconsistency with the argument that
instruments, the potential for avoidance rising transaction costs will destroy
would be slim and the costs of evasion, GDP growth and cause mayhem;
19 Andrew Haldane, high. shouldn’t falling transaction costs have
“The Contribution of then fuelled superior GDP growth?
the Financial Sector,
The strategy of any industry under Falling transaction costs have not,
Miracle or Mirage?”,
threat is to obfuscate. It is important, despite the increased role of finance
Future of Finance
Conference, June 2010.
therefore for those trying to find the in the UK, led the UK to outperform
Source: Bloomberg, truth to seek broad perspective. less “financialised” economies. Indeed,
Credit Suisse/Tremont Finance plays an important role in today, those countries growing most
and Bank of England risk taking and economic growth. The rapidly have immature financial sectors.
calculations. objective is not to emasculate finance, Perhaps the man was right, a little


16

sand in the wheels will help us from
straying too far from what is real and
sustainable.

There is another long-term positive
potential effect on growth of an
FTT, noted originally by Nobel Prize
winner James Tobin. Extremely high
remunerations in the financial sector
contribute to attract some of the
brightest graduates to financial activity,
instead of to industry or commerce, or
research on innovation. Should as a
result of the FTT, the relative incomes
and returns be relatively lowered in
boom times, it could encourage a
better allocation of our resources with
some of these very bright minds moving
to activities that could enhance the
present and future competitiveness
and capital moving to longer-term
investments like sorely needed
infrastructure for an energy scarce
world. People with similar educational
qualifications become financial
engineers in London and mechanical
engineers in Dortmund. The long-term
statistics suggest the latter is better
for long-run productivity growth. We
will not attempt to measure this effect
of improving the allocation of human
resources, but just note its qualitative
positive impact.


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