Financial transaction tax set to fall short of objectives

Commission’s proposal for FTT may not limit market instability Source: http://ec.europa.eu

The EU's proposed financial transaction tax (FTT) continues to be a topic of discussion. A number of member states have indicated a strong willingness to take this form of taxation forward. In fact, France passed legislation on March 14 to implement an FTT from August 1 this year, though at the time of going to print the scope of the French FTT is restricted to French equity and high frequency trading. How this view prevails is rather puzzling. There must be a political perspective that overrides the market view which is universally against an FTT. What is immediately apparent from the analysis so far is that there is a mass of theory and little practical evidence and a mass of conflicting views on any number of the relevant arguments. But within this mass of discussion from sources such as the IMF, various academic institutions as well as the EU itself, it is possible to detect some core positions.

The increased centralisation of clearance and trading processes today may make it easier to introduce an FTT than in the past, though the mechanism and taxing points are not agreed. It is also possible that this could be done on a jurisdiction-only basis, though the elasticity of volumes to the tax would be much greater than in a multilateral approach and hence there is a much greater risk of business migration.

A significant sum of money will come from an FTT, but realistically it is likely to be lower than estimates suggest. A broad based FTT is preferred as it allows the charge to be lower and is much harder to avoid than a narrower one. Differentiation of tax rates is essential to ensure the tax reflects the same percentage of transaction cost in each market.

The impacts are hard to assess. There are direct costs as pension funds and investment funds are designated as financial institutions (FIs), but also indirect costs that result from reduced and more fragmented liquidity, less efficient pricing and wider spreads and slower price discovery. Financial transaction taxes reduce security values and therefore raise cost of capital for issuers particularly frequent issuers. The overall cost will be more than the charge.

We will see very large reductions in derivative activity; the 70% to 90% recognised by the EU study is not disputed. The impact of business migration will reduce headcount in the industry and this release of resources will reduce the return to highly skilled labour.

In the short term the wholesale market intermediaries will bear the brunt of any new FTT. Banks and hedge funds are the most active in the short-term trading strategies which will be affected. This will change over time and possibly quite quickly. The majority of the additional tax burden will be ultimately passed on. Banks and hedge funds will reduce volumes and migrate business; corporations and non-bank FIs are less able to relocate than banks and hedge funds so will be unable to reduce their exposures. Banks and hedge fund will pass on the balance of the charges for a number of reasons such as a direct link to a client's business, but most importantly because the margin earned will be insufficient to absorb the cost.

This is particularly difficult to forecast. Market volatility will be affected, but it is not possible to say definitively in what way. The impacts of volatility will not be dispersed equally, some markets will be more affected than others; large liquid markets may do better than small illiquid markets. Volatility may not reduce and hence the markets may not be stabilised, but the reverse is equally true; volatility may go up, but markets may not become more de-stabilised.

The focus on short-term trading as an example of undesirable behaviour is misplaced. Economic thinking does not consider transaction volumes as the real issue, but instead focuses on excessive leverage giving rise to asset price bubbles. Additional charges may reduce activity levels, but will not change the fundamental valuation of securities. Prices will still move towards their equilibrium, but within a less efficient market.

There is a mixed set of reasons for wanting to tax the banks. The creation of resolution funds is popular in some quarters, but is by no means an accepted global solution, but no-one is forcibly arguing against additional contributions to pay for the past or future support. That said there is no consensus on how to manage the boundary of jurisdictional responsibility for overseas-headquartered businesses.

The suggestion that banks are under-taxed through VAT is simply incorrect. The correct analysis of the VAT situation is that business consumers (including banks) pay too much tax and individuals not enough by reference to the fundamental structure of VAT. This is a simple function of the application of the VAT rules. The numbers that have been calculated for the net additional revenues of €18 billion ($24 billion) are based on fixing this macro result. This is not the net benefit secured by banks. Proposing a tax to fix a tax break is perverse. The correct place for any review is within the green paper on VAT.

If banks must pay more tax then an FTT is not the tax of choice. An FTT is a tax on certain transactions only and is independent from who carries them out. By contrast an FAT is a tax on a bank's activities independent from which activities they stem. Like an FAT, a levy is a direct tax on the banking sector, but it is a tax on a bank's balance sheet, it is not a tax on economic rents and therefore will affect the underlying tax base. Being allied to the liability side it is not correlated to risk and is therefore questionable as an adjunct to regulatory measures. Financial transaction taxes and financial activities taxes (FAT) are similarly dismissed as supporting regulation. The consensus is an FAT is the most appropriate measure to tax banks.

Separate from the introduction of a new tax, there is growing interest in the idea of restricting interest deductibility. This fits with the economic view on excess leverage. The comparison to dividends seems less relevant. It is clear that limiting interest deductibility to banks where interest is a revenue item raises many questions and complications.

There have been many reasons given for why an FTT could be introduced. It is important that the objectives are agreed so that the effectiveness or otherwise of the tax can be measured, but the balance of opinion seems to be settling on the two objectives outlined by Manfred Bergmann, the director of indirect taxation and administration at the European Commission, in a video on the taxation and customs union section of the commission's website in February. He confirmed the purpose of an FTT is to raise money from the financial sector and to stabilise markets by limiting undesirable market behaviour. One has to be sceptical that the FTT will achieve these objectives: it may not achieve market stability, it may not raise as much as desired and is unlikely to limit this contribution to banks alone.

On that basis an FTT should be rejected. The potential side-effects are too serious to contemplate. For the UK the seriousness of the situation is evident as London has by some measures 46% of the world's OTC derivatives business. As the US has 24%, with no other country having a serious volume, we can guess where this activity would go. This may be the first pointer towards the political override, but equally the proponents may have less to lose and more to gain than those against.

Proceeding with an FTT may be a statement of strength, it may be seen to be doing something in the absence of other choices, it may perhaps reflect an over-confidence that the numbers will actually work and any adverse impacts are less or at least hidden from view. For France in particular, with only a fraction of the global market, and a rather limited version of the EU FTT proposal on offer, it could perhaps work and this would provide economic and political capital. It will certainly enable us to test some of the undisputed statements reflected above.

Philip Martin (henleydown@btinternet.com) is former co-head of global tax for Nomura.