Several members of the EU are planning to introduce a tax on financial transactions in order to raise new revenues and curtail speculative trading. This tax is sometimes called the “Tobin tax” after James Tobin, a Nobel laureate in economics, who first proposed “throwing some sand in the wheels” of currency markets in the late 1970s. Nitin Mehta of the CFA Institute explores the proposed Financial Transaction Tax (FTT)
What is the rationale for the FTT?
While surveys show that the initiative has popular support, experts are much more divided. Eleven members of the EU, including Germany, France, Italy and Spain, are planning its implementation but 15 members, including the UK, are strongly opposed.
The proponents of the tax point to several potential gains. At a time when many countries are facing budgetary pressures due to the financial crisis, the new tax would contribute towards fiscal consolidation without directly impacting the real economy. The tax might also deter excessive trading and, in the process, promote market stability and long-term investing. Financial services would no longer enjoy an exemption from value-added taxes, thereby reducing competitive distortions. Several countries impose financial transaction taxes, for example, a stamp duty on share purchases has been levied in the UK for centuries.
What are the risks?
Critics point to the potential for reduced market liquidity and the higher price volatility that may ensue. As a result, the cost of capital may rise and investment fall. Also, many financial transactions are enacted to hedge risks; the tax may discourage these and inadvertently reduce stability. In any case, opponents argue that it is hard to collect taxes on financial transactions as international traders may resist and find ways to escape them, such as relocating out of reach. Sweden experienced such displacement of trades after it introduced an FTT in the mid-1980s; the tax was abandoned after a few years and deemed to be a failure. Just as proponents provide figures for the revenues that could be collected, opponents point to the possible drag on economic growth and employment.
What kind of financial transactions will be taxed?
The current proposal covers a swath of financial transactions on organised and over-the-counter markets, affecting securities, derivatives and other instruments. At the same time, most transactions in the real economy will be out of scope: including those related to private households and smaller enterprises, primary market transactions by big businesses, public borrowing and transactions necessary to implement monetary policy. For a transaction to be taxable, at least one party would have to be an institution established in an FTT state. The focus is then on the transacting parties, and possibly the instrument, not the venue. This approach aims to cast the net wide and prevent circumvention.
What is the proposed tax rate?
Each taxable party in a transaction would be taxed at the rate of 0.01 per cent of the notional value for derivatives and 0.1 per cent of the market value for other financial instruments. The relatively low rates of taxation are designed to deter the relocation of financial institutions away from FTT states. Detailed impact assessments show that the chosen rates would not materially harm financial centres or institutions. The expectation is that about €35bn could be raised annually. Of this, about two-thirds is expected to be levied from derivative transactions and a third from other securities trading.
Who will pay the tax?
Financial institutions such as exchanges, banks and investment firms would be required to collect the tax. Some of the impact of the tax may be borne by market makers if they narrowed bid-ask spreads. According to a survey carried out in July 2011 of CFA Institute members in Europe, many of whom work for financial intermediaries, most of the burden of the tax is likely to be passed on to end investors. Investment vehicles with strategies that require frequent trading will probably suffer the most tax drag.
What is next?
If everything goes according to plan, the FTT becomes law in the 11 adopting EU states from January 1 2014. Widespread objections from many other countries, together with threats of lawsuits from financial institutions, may delay the pace and dilute the form of implementation. But there seems an urgent determination to proceed. Reducing the territoriality of the tax, narrowing the range of transactions covered and exempting some institutions such as pension funds are just some of the possible compromises.