The financial transaction tax (FTT) has long been taboo on the U.S. and European economic policy scenes alike. Tides appear to be changing however, following an announcement in February by Senator Tom Harkin, an Iowa Democrat, and Representative Peter DeFazio, an Oregon Democrat, to reintroduce a bill calling for an FTT. This comes after the decision of 11 European countries to begin a process of enhanced cooperation on the FTT, an endeavour approved by the European Parliament in December 2012. Along with renewed attention to the tax come also corresponding doubts, which ultimately still shift the balance against an FTT.
FTTs have a two-fold aim: to raise revenue and reduce the activity falling under the scope of the tax. An additional source of revenue for the government in times of economic difficulties has made the tax appealing on the former front. A desire to make the financial sector bear some of the crisis burden has justified the latter aim.
The original idea for an FTT goes back to American economist James Tobin, who circulated it during the 1970s in the exchange rate context. The issue became more relevant along with the rapid increase in the volume of financial transactions in the run-up to the crisis. Trading activity growth exceeded the expansion of economic activity. For instance, in 2007, total financial transaction turnover reached almost 70 times world GDP.
European developments on the FTT front accelerated in the fall of 2011, at a time when a tax on financial transactions emerged as a potential source of funding for the EU budget and also as a form of punishment for the financial sector and its contribution to the crisis. With these arguments in mind, the European Commission put forward a proposal for a directive on an FTT in September 2011. The proposal then came under the scrutiny of the European Parliament, which delivered a favourable opinion on it in May 2012. When taken up in Council however, the proposal failed to get the unanimous agreement of the 27 member states.
Lacking other options, those member states in favour of the tax resorted to the enhanced cooperation tool offered by the Treaty. The list of member states includes Belgium, Germany, Spain, France, Italy, Austria, Portugal, Estonia, Slovenia and Slovakia. According to article 20 of the Treaty on European Union, enhanced cooperation allows a number of member states to unite forces on certain issues, within the bounds of the Treaty, when unanimous agreement at the union level cannot be achieved.
On 14 February this year, the European Commission released a new proposal for an FTT to be implemented by the 11 member states under enhanced cooperation. Transactions with an established link to one of the 11 parties will face a levy of 0.1 per cent for shares and bonds and 0.01 per cent for derivatives. The tax will furthermore follow a 'residence principle' whereby revenue will be collected provided at least one of the parties to a transaction is established in a member stated involved in enhanced cooperation. The residence principle will not be concerned with the location where the transaction actually takes place. Moreover, the FTT will also follow the 'issuance principle', whereby the financial instruments issued in a member state which has adopted the FTT will be taxed when traded, regardless of whether the entities participating in the trade have adopted the tax. The expected revenue capacity of the tax is estimated at 30bn EUR. The 11 member states which have entered into enhanced cooperation will now be allowed to vote on the Commission directive, with unanimity required before the tax can be put in place.
Looking at what impact the FTT will have on the European economy, we still have strong reasons to remain cautious. The tax can be countered with its headline targets in mind.
Let us first consider the desire to make the financial sector bear the burden of the crisis:
Even though the FTT has been perceived largely as a punishment of the financial sector, the tax might end up being a burden to the real economy and its actors. It can have a negative impact on long term growth and employment through the increase of capital costs, at a time when Europe desperately needs growth. Moreover, the tax can trickle down to the weakest segments of society and impact pensioners.
EU-based pension funds would have to pay the tax when buying or selling investments or making use of derivatives to hedge against inflation. Thus the FTT would effectively multiply the tax rate paid by pension funds by impacting investments which are part of long-term investment strategies and short-term risky transactions alike. In turn it may put off non-EU investors when deciding whether to carry out a transaction with an EU-based pension fund. This would directly hit the beneficiaries, who would end up bearing the burden of the financial crisis once more.
The example of pension funds and growth prospects highlights the economic consequences of a largely debatable tax. These arguments should serve as a reminder that tax decisions should not be politicised, but remain ultimately economic decisions.
Let us now look at the FTT's second aim, namely to raise revenue and reduce the activity falling under the scope of the tax. For the FTT to be successful, the revenue raised needs to justify the imposition of the tax and an economic rationale needs to exist for policymakers to want to regulate the activity concerned. Here once more, the arguments in favour of the FTT are not that obvious.
We should remain pragmatic and see that there is practically no chance of imposing an FTT at the global level. If Europe goes for it on its own, as 11 of its member states have already started, it will face a risk of a displacement of economic activity, rendering the revenue capacity of the tax extremely limited. Recent history bears witness to such episodes. A number of British companies relocated to Ireland when the UK imposed the stamp duty. Sweden provides an even more striking lesson on the FTT front. Sweden initially imposed a tax on transactions on stocks and stock-based derivatives in 1984. The initial impact of the tax was modest in terms of revenue raised. This in turn led to a doubling of tax rates in 1986. The effects were dramatic. Transactions were shifted to non-Swedish brokers based abroad and 60 percent of the trading volume in the most actively traded Swedish stock classes moved to London. Tax revenues remained small as a result. This experience led to a phasing-out of the tax and eventually to its repeal in 1991. The Swedish example should remind us that financial relocation is not a costly endeavour and may easily come about.
Not only the global scope of the tax and the relocation risk can be challenged however. We can have doubts also about whether an FTT would contribute to the prevention of a future financial collapse, as some have argued it would do by discouraging speculative transactions. Not all speculation however is short-term and not all short-term transactions are speculative. We know very well that the CDOs which were at the root of the crisis were medium to long term instruments. Beyond this, we should remember that speculation is not intrinsically bad. Trading volumes will almost certainly decrease as a result of the introduction of an FTT, which will increase price volatility. This in turn will lead to more disruptive speculation. Beyond this, fewer transactions will weaken the capacity of prices to convey information and will bring about higher costs. This is a high price to pay, especially since an FTT will most likely not lead to a reduction in high risk behaviour, but will be more costly for those generating smaller risks than for those generating systemic threats.
Moreover, what many people seem to forget is that the crisis was not caused by a too high frequency of trading in financial products. In fact, the crisis started as a liquidity crisis and a credit crunch. A tax on financial transactions might decrease the liquidity of the market even further due to the increased transaction cost.
That only leaves one argument in favour of an FTT, which is the revenue that it might raise. But if the purpose of the tax is that of eliminating some transactions, the tax base will go down, and revenue will be affected.
Europe has now embarked on a controlled experiment in uncharted waters. Its use of enhanced cooperation in order to bring it about will only divide Europe further. The wheels of change have however already been set in motions and only time will tell whether the FTT can achieve its promised targets and mitigate potential risks.