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  • 1. THE ECONOMIC CONSEQUENCES OF THE EU PROPOSAL FOR A FINANCIAL TRANSACTION TAX AVINASH PERSAUD March 2012nd and Wales (registration no. 5382993) Intelligence Capital Limited is duly incorporated and registered in England and Wales (registration no. 5382993)
  • 2. 02 paid expertise, innovation, credibilityTHE ECONOMIC and connectivity of our bankers notCONSEQUENCES OF compete against a tax of one tenthTHE EU PROPOSAL of one percent? This is the largest sector in the UK, are its fortunes reallyFOR A FINANCIAL hanging on such a thin thread. OneTRANSACTION TAX wonders how much valued added our financial sector can bring if it can be soAVINASH PERSAUD1 threatened by so small a tax. You would also be excused fromMarch 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 transaction1. INTRODUCTION costs such as trading commissions, spreads, price-impact of trading,There is no subject certain to raise the clearing, settlement, exchange feeshackles of London bankers more than and administration costs which,a financial transaction tax. In terms of just ten years ago, were collectively 1 Chairman, Intelligenceunleashing a torrent of abuse, it even greater than they are today in the Capital Limited, Emeritusedges out the European Commission. equity markets, by the amount of the Professor of GreshamNo surprise then, at the strength of the proposed tax. College and Fellow,reaction to the proposal in September London Business School. The ideas presented2011 by the European Commission for If tiny levies on trading activities would in this report benefitan EU wide, 0.1% tax on transactions cause such damage to the wider from conversations andcarried out by financial intermediaries economy, investment and jobs, why collaboration with aon equities and bonds, and a 0.01% do the fees and charges by banks and number of people tootax on transactions in derivatives. funds on the same trading activities of many to name, but most $100bn in the US and proportionately recently from ProfessorsThe traditional response of all powerful more elsewhere, not come in for Stephany Griffth-Jonesindustries 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 Kennethbanking today, is to pursue a strategy manipulation by some bankers of the French documents thatof obfuscation. What draws me to this British Bankers Association’s LIBOR U.S. investors spent ansubject is not the “bashing bankers” reference rates, on which $375trn average of 0.67% of theparty, but the disproportionate, of transactions are priced every day, aggregate value of theinconsistent and disingenuous was for many months greater than the market each year overarguments used by my fellow bankers impact of a 0.1% transaction tax. But the period 1980-2006against this proposal. The purpose we will not see the economic and job in searching for superiorof this paper is to provide greater costs to the wider economy of this returns includes trading commissions as wellperspective to the issues of revenues, manipulation. It will be brushed off as as the fees chargedavoidance and economic impact of a unfortunate, these things happen, and by mutual funds andfinancial 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 activethink that a 0.1% tax would usher the provision of public services, some investing, Journal ofin 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
  • 3. 03impact of tiny transaction taxes while largest economies on the continent,reaping far greater sums from fees, Germany, France and Italy, the tax willcommissions and dealing profits, some likely raise £18bn and if levied in theof 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 raiseIn their zeal to come up with examples £8.4bn through an FTT, it could,of complicated off-shore, off-balance instead of tinkering with corporationsheet transactions that could potentially tax over time, lower it in one swoopevade this tax, some bankers appear to to 18% making it the lowest in thehave forgotten that they are a regulated OECD, bar Ireland, and as a resultactivity and today, supervisors will make an impressive claim to promoterequire capital to be put aside for real business. Alternatively, it couldactivities that create risks. scrap the 50% higher income tax bracket many times over, it could avoidPerhaps most importantly of all, this all of the £8bn cuts to the educationfinancial crisis, even more than others, budget or more than double the UK’shas taught us that while low transaction aid spending.costs are generally good, it is badif they get so small that they are no To determine how much a transactionlonger any hindrance to activities, tax would raise, we need to know howthat through rapid turnover, give the much the demand for transactionsimpression of great citadels of value in the taxing jurisdiction will fall as abut turn out to be merely castles in consequence of the tax. If demand forthe sky. Moreover, the lower are transactions were inelastic to a risetransaction costs, the greater are in transaction costs, then the tax takegross exposures to net exposures and would merely be the product of the taxthis gap represents the vulnerability rate and the number of transactions.of a financial system to shocks where This would be a mouth wateringeveryone turns to the exit at the same £150bn around the G20 countries, buttime abandoning all of their losing such an outcome is unlikely.trades. Small transaction costs willtherefore bring economic benefits as Critics of FTTs argue that transactionwell as genuine economic costs. We taxes will not raise significantexamine the net effect of these. sums because transactions are highly sensitive to small changes in transaction costs, which are already2. HOW MUCH WOULD AN quite small. They say the bulk ofFTT RAISE IN THE EU AND financial transactions will eitherIN THE UK? disappear, or bankers would find ways of routing them elsewhere toAccording to the EU Commission avoid paying taxes. The same criticsstudy, it is likely that a 0.1% Financial argue that this would have enormousTransaction Tax (FTT) levied across the economic consequences. It does notEU on equity and bond transactions entirely add up that transactions ofand a 0.01% tax on transactions in great economic value would be snuffedderivatives will raise over £48bn. out by the tiniest rise in transactionLevied across the nine countries that costs, but it is theoretically possible.have announced their willingness to It is part of the obfuscation strategy ofproceed on their own, including the invoking the fear of the unknown. TheI 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
  • 4. 04Table 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 financialtransaction taxes, of the equivalent transaction taxes. Almost half of thissmall increases in transaction costs, revenue is raised by the UK andwill 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 EXPERIENCEWITH 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, existingby financial transaction taxes, in FTTs across countries and instrumentsdynamic economies, without bringing will be raising $37bn (£25.3bn) peron armageddon. Seven countries annum. 3 See, Romano (2011).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
  • 5. 05 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, bonds4 Under Section 31 “Section 31 fees” after section 31 of were bearer instruments and thereof 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 towardsorganizations (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 financeIndustry RegulatoryAuthority (FINRA) in - and are likely to rise again given the and anti-money laundering rules andand 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 bondStock Exchange and picture through time. Stamp taxes are markets have lower volatilities, lowerthe American Stock old and common5. Before the financial elasticities and lower trading spreads itExchange) - must pay crisis when the sector convinced us could be argued for a lower rate than istransaction fees to the that nothing should stand in the way of appropriate for equities rather than theSEC based on the more trading, some of these taxes were same rate. The EU Commission alreadyvolume of securities that taken off or moderated as their yield accept the principal of differentiatingare sold on their markets.These fees recover the grew so large as was the case with the the taxes for different securities incosts incurred by the US securities tax. More recently, some regards to derivatives.government, including have been reintroduced. One of thethe SEC, for supervising essential lessons from the history ofand regulating the these taxes, is that this is a policy that 2.2 ESTIMATINGsecurities markets and can be tried and, if it proves too costly, THE IMPACT OF THEsecurities professionals. reversed relatively easily and quickly. PROPOSED TAX5 The first stamp tax The US Section 31 fees have beenwas first devised in the lowered 9 times and raised 7 times The impact of a transaction tax on theNetherlands in 1624 since 1934 without stir. demand for a transaction is the sameafter a public competition as any other transaction cost, suchto find a new form of tax. The “revealed preference” from those as clearing and settlement, trading 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
  • 6. 06commissions, dealers spreads, price during the transaction there would beimpact of trading, fund management dealer costs and afterwards clearingfees etc. Indeed, the economic and settlement costs, custody andimpact of the State raising £8.4n reporting costs. The decision to buyfrom transactions is the same as the BP shares is based on an investmenteconomic impact of the banks, brokers, view that investors in the fund wouldmutual 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 havefund managers that complain loudest complained that all of the costs fundabout financial transaction taxes hurting managers deduct over and above fundthe 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 totalThe economic impact of a transaction transaction costs are in excess oftax is also the same as if dealing 0.67%8 per annum. Measured againstspreads (the difference between the total transaction costs, the proposedpurchasing price and selling price of 0.1%, FTT is less than 10% of totalan instrument) were to widen by the transaction costs.equivalent amount, or were to returnto a level greater than current levels by Studies of dealing-related costs,the amount of the tax. Spreads were excluding research, administrative0.1% greater than current levels in the and managers fees, but includingmost liquid markets as recently as ten commissions, spreads, clearing andyears ago – see the progress of spread settlement costs indicate that thedecline in the US market in table 2. elasticities of demand for equities of a rise in transaction costs are in theIn order to estimate revenues, a number region of 0.25 to 1.65, averagingof studies have tried to determine around 0.6. This implies that a 1% risethe 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. Givenissue of contention was what we that we are not including all transactionmean 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 dealercommissions which are now quite These point estimates of elasticitiessmall - one or two basis points - for the are also likely to be an over-estimatemarkets with greatest turnover, though of the effect of very modest rises inthey were higher by the amount of transaction costs. Below a certain sizethe proposed FTT just ten years ago, of transaction costs, the level of generalsee table 2. However, as Professor uncertainties, including the likelihoodKenneth French (2008) observed, of the asset price changing during the 6 French (2008) – seethese 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 fromIf we were to read in the newspapers a further reduction in administrative 7 For a recent reviewthat a mutual fund buy shares in BP, transaction costs bring little benefit. It is of the results of these studies, see McCullochbefore 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 despiteprofessionals, there would have been advances in trading technologies. The 8 French (2008) – seeresearch and administrative costs, investment literature generally shows footnote 2.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
  • 7. 07 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 UNDUE9 For an interesting here, have little impact on investment BUSINESS OVERSEASstudy on the elasticities demand9.of investment in general Capturing the tax paid by residentsto transaction taxes The revealed preference across and non-residents on buying or sellingwhere the potential for countries with existing FTTs and the instruments issued by issuers residentsubstitution is high, empirical analysis suggests that the in the country will be easy with verysee “Taxes, the Cost ofCapital, and Investment: a 0.1% tax would have a modest limited opportunity for avoidanceA Comparison of Canada impact on demand, ranging from 5% or evasion. This would representand the United States.” to 15% in different markets, and would over 50% of tax revenues in mostKenneth J. McKenzie and therefore, despite its low level, yield jurisdictions.Aileen J. Thompson, April significant sums. Based on a survey of1997. 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 along tradition in many that €57bn per annum could be raised corporates or individuals - on thecountries including if all EU countries adopted a 0.1% transfer of ownership of a residentMalaysia, Netherlands, securities tax for equities and bonds security. Where “stamp taxes” areIreland, 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 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
  • 8. 08be legally enforced, and there can be French bank in New York, to buy a UKno registered change of ownership to security will still have to pay the taxlocal or foreign buyers until taxes are because otherwise he will not receivepaid to, and stamped by the authorities. legal title to the security and could notNon-enforceability of contract is a very receive any dividends, rights and claimshigh consequence of non-compliance and his contract to buy the shareswith the stamp duty. It is particularly would be unenforceable in the relevantso where registered owners of assets jurisdiction. This is too high a risk forare due to receive certain benefits investors to take – no pension fundand rights like voting at shareholder trustee would take such a risk. Taxingmeetings, dividends, interest coupons, by residence of issuer is therefore farrights issues, buy-outs etc. These more effective with very limited scopestamp taxes are collected at settlement for evasion which is why stamp dutieswhere change in registered ownership on financial transactions already raisetakes 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 thaton transactions per se and so the a very high proportion of those payingcompliance of brokers around the these taxes are in fact non-resident ofworld, in New York or Beijing is not the country imposing the tax – in thenecessary). case of the UK it is estimated that 40% of the Stamp Duty Reserve Tax on UKIn order for the authorities to tax a equities is paid by non-UK-residents.transfer of ownership, the registerof owners has to be held in their The 0.5% Swedish financial transactionjurisdiction and hence the issuer of tax that was introduced in Januarycertificates of ownership (shares) 1984, on the purchase or sale of anwould 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 abut the same argument could apply to stamp tax on the transfer of ownership,changes in corporation tax and much but was levied on residents buyinglarger differences in corporation tax a local share and collected by localbetween jurisdictions have proven brokers. It could be avoided by asustainable. Within the OECD, resident buying overseas an untaxedcorporation tax rates vary from 12.5% foreign security where the security wasto 40% and even when the extremes a holding of a share local to the taxof Japan and Ireland are removed there payer. The tax was relatively high andare still differences of 5% or more that there were easy, untaxed, substitutesprove sustainable despite the footloose for Swedish securities. Avoiding thenature of enterprise today. Moreover, tax was a high-return, low risk venturethis tax has an indirect impact on the and so many Swedes routed theircost of capital for companies as it purchases through London entitiesis paid directly by resident and non- that presented themselves as overseasresident investors in the secondary buyers of Swedish stocks. Swedishmarkets whose tax payment is highly brokers felt particularly hard done byvariable depending on the frequency of as their business had merely switchedtrading. to foreign brokers. Despite raising over $1bn per year, the Swedes scrappedStamp duties are nigh on impossible this tax because of the iniquity that onlyto avoid. A Chinese investor, using a half were paying it.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
  • 9. 09There are two ways to stem this leak. 3.1 DERIVATIVES,First, if it were a “stamp tax”, then the CONTRACTS FORtax resident masquerading as a foreign DIFFERENCES ANDresident, would still be liable for the LONDONtax when buying the local share. Thiswould have substantially plugged It is often argued that if there were athe hole in the case of Sweden. But tax on transacting financial instruments,secondly, residents could be further market participants would switch to theliable for the tax on the purchase or derivatives market where the tax couldsale of any security and therefore even not be levied because derivatives arebuying foreign securities, irrespective invariably not issued by the issuer ofof whether their underlying holdings the underlying security. The footloosewere local securities or not, would not nature of derivatives would then leadbe a way of avoiding the tax. This would the largely London-based derivativereduce the incidence of avoidance market to decamp to another untaxingsignificantly and would also capture jurisdiction, carrying jobs and GDP. Theforeign issued derivative instruments threat of decamping is often used byon local stocks. There will still be those companies and industries to lever lesswho try to evade the tax by establishing taxes and regulation but as this lastthemselves up overseas, which they financial crisis has taught us the long-can also do to avoid many other taxes term, wider, consequences of giving inwhere evasion exists but not enough to such threats are likely to outweighto undermine income tax, corporation the benefits.tax and capital gains taxes. But this isnot only illegal, it is also costly. Setting From a tax raising perspective, if theup, illegal, parallel structures to trade taxes are due if either the instrument oroverseas instruments and then to find the investor is resident, then investorsillegal conduits to return funds when resident in London would still pay therequired, is not costless or risk-free. tax whether the market had stayed inIt is not a cost or risk that institutional London or moved to Timbuktoo. Thereinvestors, regulated or publicly listed would be a loss of revenue from non-entities - the bulk of investors in stocks residents if the market went elsewhereand bonds - could carry. Even without and perhaps jobs and GDP. But wouldan FTT, internal revenue agencies in the market decamp in response to athe US, UK, Germany, France, Spain one hundredth of one percent tax?and elsewhere are cracking down on Are the benefits of a concentration ofresidents who hold assets abroad and liquidity, expertise, connectivity and ando not declare any tax liabilities they overall favourable fiscal environmentmay have. Moreover, new regulatory in London not worth that? If not, onerequirements we spoke of before, in wonders what is the benefit of havingparticular for mandatory reporting of this business? And if the people andall trades, on or off exchanges, make institutions stayed, but trades wereevasion through non-reporting harder merely booked somewhere else, thenthan 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 unlikelyI 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
  • 10. 10that the derivatives market would be unenforceable if the contract wereexecute their threat to decamp. We will not stamped. It is important to note thatreturn to the issue of jobs and GDP even if one investor were prepared tolater. 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 toWOULD 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 instrumentswhich are not-taxed and are thereforenot legally enforced, could not be 3.3 IMPLEMENTATIONconsidered eligible for central clearing ISSUESby a clearing house. This is of crucialimportance today and represents Given all that we have discussedone of the ways in which financial above, it would be important for thetransaction taxes are far more feasible Financial Transaction Tax to be levied inthan before, even for derivative two complimentary, but separate ways,instruments. One of the responses to first, as a tax on the transfer of legalthe financial crisis by the G20 and the ownership of locally issued securities.Financial Stability Board is a regulatory No special mechanisms are needed torequirement that all exchange traded implement this. The revenue authoritiesinstruments, including equities, bonds, can establish automatic electronicderivatives and all vanilla over-the- stamping of certificates where there arecounter transactions such as credit automatic electronic payment schemesdefault swaps, must be centrally and these are likely to be establishedcleared. Instruments held by financial by payment settlement agents. Thisinstitutions that are not centrally is already in place in many countries.cleared will incur a capital adequacy The UK SDRT is mechanically paid torequirement11 - 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 inThe consequences therefore of holding long-time were physically in Belgium. September 2009, states:non-taxed instruments, in terms of loss “all standardized OTCof legal certainty, higher counter-party Secondly, an FTT on foreign securities, derivatives contractsrisk, loss of gains from netting in a at the same rate as for local securities should be traded onclearing house, and the cost of higher would be required to be paid by exchanges or electroniccapital 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 throughderivatives will be centrally cleared and the information required to calculate central counterpartiesthose that are not, are highly bespoke the transaction tax is already declared. by end-2012 at the latest”…“OTCcomplex contracts that the clearers Additionally, there is often a withholding derivatives contractsdon’t want to clear because they tax on dividends to foreign residents should be reported toare so specialized and are therefore and so there is a substantial incentive trade repositories,” andunlikely to be frequently traded. Of – far greater than the tax – to declare “Non-centrally clearedcourse even the non-centrally cleared the transaction in order to receive a tax contracts should beinstruments would be subject to the rebate from the foreign tax authorities. subject to higher capitaltax and the derivative contract would New reporting requirements on all requirements.”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
  • 11. 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 a12 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 costwith Professor Stephany the impact on GDP of a 0.1% FTT of capital if revenues from the FTT wereGriffith-Jones who levied across the EU on equity and used to lower corporation tax on profitscontributed by far bond transactions and a 0.01% tax by 10 percentage points? Given thatthe greater portion of on transactions in derivatives. The in the UK in particular, that 40% ofinsight, 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 revenues13 Based on most recent and measured the GDP impact of that of an FTT were used to reduce theEC 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 lowercompanies are assumed model, the initial output of the model the cost of capital in the UK, therebyby the Commission to be was a potential GDP loss of 1.76%. boosting employment. It is certainly theprimary 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 growthThe 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 andnonfinancial corporations a highly disingenuous conclusion, as Switzerland.could be estimated at the Commission later moderated thisabout 15% (or about figure to -0.5% to take into account a5% of total financing). number of mitigating factors and more 4.1 IMPROVINGAs we discussed above, recently, having adjusted for the reality FINANCIAL STABILITYthis mitigating factor is that UK and other European companies & RESILIENCEnow incorporated into are not generally funded through thethe second version of themodel, see again Lendvai primary issuance of new equity, they If the FTT reduces certain financialand Raciborki, op cit. have further revised down this figure to market distortions and thus systemicThis implies the growth -0.2%13. risk, it can – by reducing the risk ofeffects of FTT are now future crises - lead to significantlydown to -0.2% of GDP. Considering other mitigating factors to higher long-term growth. There is here 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
  • 12. 12a parallel with the argument, made, for as well as buyers in crashes. Findingexample, in the paper by Miles (2011), value is a long-term endeavour andfrom the Bank of England’s Monetary can lead to many short-term losses.Policy Committee, arguing for higher Consequently the other kind of traderscapital adequacy requirements for are “noise traders” that focus on trends.banks and modeling that part of their Rather than stubbornly selling into aimpact as positive for growth as it boom, they will buy and benefit in thereduces systemic risk and therefore short-term. But the more buying therethe probability of future crises. Crises is in a boom the longer the boom andclearly always lead to periods of greater the fall. The more noise traderssubstantially lower or more often, there are, Blanchard and Summerssignificantly negative growth (for eight showed, the more likely we will getcenturies of empirical evidence on the misalignments in markets (up andlink between crises and lower growth, down) and consequently, the moresee Reinhart and Rogoff, for a recent savage are the adjustments back.assessment of the negative effectsof 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 getsWe 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 costsof crises, as prudent macroeconomic limits the ability to make high but verypolicies, and effective financial short-term returns and will limit theregulation as well as supervision, amount of “noise trading”. By doing sohave the major role to play in crisis the FTT would make a contribution toprevention, but it may have a role to the reduction of severe misalignmentsplay. and hence the probability of violent adjustments. Relatedly, but separately, in financial crises “gross” exposures4.2 BOOMS TO CRASHES matter more than the net as scared investors run for the exit, and financialIt is tempting to consider financial transaction taxes will reduce the gapcrashes as relatively random events of between the two and reduce financialpiracy, but in reality financial crashes vulnerability.invariably follow financial booms andthe 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) estimatesprevention, therefore, is limiting the that, from peak to trough, the averagesize of booms. In their seminal work fall in per capita GDP, as a result ofin this area, Olivier Blanchard and major financial crises, was 9%. TheLarry Summers, showed that booms Institute of Fiscal Studies (2011)can get large and become self- has recently estimated that for thesustaining if there is a pre-ponderence UK, when comparing the real medianof “noise traders” in the market. They income household income in 2009-postulated that there were broadly 2010 with 2012-2013, the declinetwo kinds of traders, one that they will be 7.4%. Of course for Europeancalled “fundamental traders” who seek countries directly hit by the sovereignvalue and would tend to be sellers debt crisis, like Greece, the decline ofduring booms, when financial prices GDP and incomes will be far higher,rise above historical metrics of value, though they are unlikely to approachI 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
  • 13. 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 is14 One of the impact estimated by the Commission not a good description of the bankingobservations of Adair model of -0.1%, with the positive one industry. In the years outside of bankingTurner, Chairman of the just estimated of +0.35%). These are crashes returns to capital and labourFSA, shared by others, not big numbers but they do imply are superior to other industries andis that the collapseof transaction costs a positive impact on employment of so it is possible for part of this tax totowards zero facilitated 75,000 in the UK alone. be paid by the industry through lowerthe creation of huge profits. The top 1,000 banks in thederivative markets world reported collective profits ofbalancing on relatively 4.3 FINANCIAL MARKET £540bn in 2008, before collapsingsmall underlying markets, LIQUIDITY in 2009 and rebounding to £267bn.which made financial To preserve market share banks maysystems more vulnerable Creating disincentives for short-term well decide to swallow a tax thatin a crisis. The optimal speculation (as opposed to long- represents in a good year less thanlevel of transaction taxes term investment) is considered an 10% of profits. But what of the portionmay be low, but it is notzero. 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 fundsbehaviour is well Tobin in favour of transaction taxes14. and insurance companies will pay leastdescribed in “Positive Others suggest this might undermine and short-term speculators like hedgefeedback 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 rationalspeculation”, J. Bradford of liquidity, financial market liquidity is regulatory agencies only allow hedgede Long, A. Shleifer, about diversity: when you want to sell, funds to market to high net worthL. H.Summers and R. someone wants to buy because they individuals, this tax will be progressiveWaldman, Journal of have a different valuation or investment with banking and hedge fund profitsFinance, June 1990. goal or strategy. tapped more than pensions. 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
  • 14. 14Table 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 44Source: UK National Statistics, London Stock Exchange and IMA calculationsAccording to the data above, the crashes occur on average every 10average UK pension fund holds a stock years. We point out above that financialin 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 taxa 0.1% transaction tax for buying and of 0.1% reduced the role of “noiseselling and every 3.5 years a pension traders” which reduced the size offund has bought and sold 50% of its misalignments in markets, whichportfolio, the average pensions fund reduced the incidence of financialwould pay transaction taxes equivalent crashes by just 5%, and this reduced 16 The rough calculationto 0.03%16. This compares with annual risk and uncertainty boosted returns, is (0.001 (tax) x 2 (bothmanagement 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) xwhich are twenty three times the 0.03% cost of the tax18. 0.3 (in one year and notincidence of the tax. 3.5) x 100) per year. The actual equation would have to take 17 The rough calculationA High Frequency Trader turning over into account whether the reduction in is (0.001 (tax) x 2 (bothits 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) perpension 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 calculationfrequency trading falls off dramatically. need for precautionary behavior and is (0.33 (loss given aThe cost of financial crashes is as increases the sustainable rate of return, crash) x 0.05 (reducedheavy for investors as it is for most but the essential point is that the cost likelihood of a crash) xothers. 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).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
  • 15. 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 financeFuture of FinanceConference, June 2010. therefore for those trying to find the in the UK, led the UK to outperformSource: Bloomberg, truth to seek broad perspective. less “financialised” economies. Indeed,Credit Suisse/Tremont Finance plays an important role in today, those countries growing mostand 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 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
  • 16. 16sand in the wheels will help us fromstraying too far from what is real andsustainable.There is another long-term positivepotential effect on growth of anFTT, noted originally by Nobel Prizewinner James Tobin. Extremely highremunerations in the financial sectorcontribute to attract some of thebrightest graduates to financial activity,instead of to industry or commerce, orresearch on innovation. Should as aresult of the FTT, the relative incomesand returns be relatively lowered inboom times, it could encourage abetter allocation of our resources withsome of these very bright minds movingto activities that could enhance thepresent and future competitivenessand capital moving to longer-terminvestments like sorely neededinfrastructure for an energy scarceworld. People with similar educationalqualifications become financialengineers in London and mechanicalengineers in Dortmund. The long-termstatistics suggest the latter is betterfor long-run productivity growth. Wewill not attempt to measure this effectof improving the allocation of humanresources, but just note its qualitativepositive impact.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