Argentina and China have done it for years, with little apparent harm to their economies. The French say they’re doing it too, and they want the Germans to bring the rest of Europe along. The Brits have been doing something similar for centuries, but they aren’t going to join this one.
In the United States, President Barack Obama is noncommittal on a transaction tax (despite reports to the contrary), but Iowa Senator Tom Harkin and Oregon Representative Peter DeFazio – both Democrats – have embraced the idea of doing it here.
We’re talking, of course, about the imposition of a financial transaction tax (FTT) on trades in financial instruments. The specifics are vague, but most proposals are in the neighborhood of a 0.25% tax on equities and a 0.01% tax on the notional value of derivatives, with the money going into a pot to cover everything from regulatory costs to the next bailout of the financial sector to remuneration for the last one. Various FTTs have been either proposed or implemented in more than 20 countries to date – most recently in France, where President Nicolas Szarkozy has promised to unilaterally implement one beginning in August.
Szarkozy says that the French FTT will eventually blend into an EU-wide FTT, and has implied that he’ll abandon it if other countries don’t follow suit. It’s not yet clear, however, whether his transitional FTT will cover transactions that take place within the country or be extended to transactions that French banks execute around the world. He also hasn’t said much about how the FTT will be assessed or how the income it generates will be spent.
All of these are critical issues that go to the heart of what an FTT can or cannot accomplish – in part because if one country implements an FTT on its domestic exchange and its neighbors don’t, then trading can simply migrate cross-border. That’s what happened to Sweden in the 1980s, but their massive 100-basis-point tax on every purchase or sale of equities was many time higher than the FTTs currently being proposed. Despite the difference, much of the push back against such a tax is expected to come from countries like Sweden, who had a very bad experience in the past with it and don’t want to go through it again.
Still, the flight risk remains, and that means any tax, to be effective, must at least be built on generally-accepted principles. Former JP Morgan Managing Director John Fullerton supports an FTT, but adds that it’s more important to remove perverse incentives that reward irresponsible risk-taking – including, for example, laws that let people write off interest payments for debt.
“More important than the details of the FTT are the importance of fixing capital gains so that it encourages some things and discourages other things, which in itself would be difficult to do,” he says. “That’s more important than whether the FTT is x basis points or y basis points.”
Most practitioners say that it’s impossible to get the world’s nations to agree on a transaction tax, leaving the issue dead in the water.
“The G-20 couldn’t agree on a bank levy, and half the Asian countries said, ‘No, we’re not going to have anything to do with it, but if you guys want to go ahead, then please do. In fact, we’d like it if you did,’” says Anthony Belchambers, Chief Executive Officer of the UK’s Futures and Options Association. “Frankly, the same argument applies to a financial transaction tax. The moment you bring it up, those same countries will say, ‘We understand you have a problem and we understand why you want to introduce [a financial transaction tax], but don’t expect us to do it also.’”
He adds, however, that if both France and Germany get behind something, the rest of Europe will at least stand up and pay attention. Indeed, many European legislators are exploring the possibility of imposing such a tax as a block, perhaps on euro-denominated transactions. If that flies, the UK will end up participating whether it wants to or not.
But that still leaves unanswered the larger question of whether a financial tax can act as a remedial action for markets. The structure of the tax is, therefore, just as important as the geographical area over which it’s implemented and the way it’s spent.
Efficiency vs. Resiliency
The arguments for and against an FTT are best understood as part of a much larger debate – one that Fullerton characterizes as an effort to balance efficiency and resiliency. “Both efficiency and resiliency are hard to define, but basically efficiency is the ability of a system to grow and expand and process throughput, while resiliency is the ability of a system to recover from a shock,” he says. “Economics has tended to focus on maximizing efficiency, but resiliency is only now getting widespread attention.”
He advocates a tax because he says the financial system has not only become efficient and fragile, but it has remade the global economy in its image by trimming fat wherever it goes. For him, an FTT is something like fire insurance – it pulls money out in fat times, but offers a cushion in lean times.
HFT: Collateral Damage?
An FTT would, however, hit high-frequency traders the hardest – and it’s not at all clear their activities are the ones causing disruption, as we saw in “High-Frequency Trading: Good, Bad Or Just Different?” Indeed, spreads have never been narrower, and the real threat to economic resiliency arguably comes from unregulated over-the-counter markets than from exchange-traded markets.
Fullerton concedes the point, but argues that the pennies we save from tight spreads aren’t worth the resources being devoted to high-frequency trading.
“If someone is truly investing, then the impact that this will have on their returns is so minimal that they really shouldn’t care, and by definition it will shift a lot of capital out of this high-frequency trading stuff and into real activities,” Fullerton says. “Efficiency in secondary markets is the flea on the back of an elephant, and not the elephant itself.”
Fullerton is, obviously, in the minority among his financial-sector peers – but it’s a minority populated by hitters like John Bogle, founder of the Vangard Mutual Fund.
“I support a transfer tax on securities transactions, primarily as a way to slow the rampant speculation that has created such havoc in our financial markets, but also for its revenue-raising potential in this time of staggering government deficits,” wrote Bogle, on the Wealth for the Common Good web site, which Fullerton also supports.
On the other side, you have people like Harvard Economist Ken Rogoff who argues that an FTT will have knock-on effects throughout the economy.
“Higher transactions taxes increase the cost of capital, ultimately lowering investment,” he wrote back in October. “With a lower capital stock, output would trend downward, reducing government revenues and substantially offsetting the direct gain from the tax. In the long run, wages would fall, and ordinary workers would end up bearing a significant share of the cost.”
It’s difficult to find studies that support either side, and those that have tried to calculate the cost of an FTT, like a recent report issued by the Ernst and Young ITEM Club, have focused on losses in the financial sector only.
Nuts and Bolts
The National Futures Association (NFA) supports itself in part by charging a small “assessment fee” of $.04 per round-turn on futures trades, and the agency’s existence helps keep the futures industry both honest and alive. That, essentially, is the argument that proponents of FTTs are making as well, and there is no shortage of tax proposals or of academic exploration into what will happen under this tax or that one, and much of it is quite specific.
The bulk of the arguments have been summarized best in two International Monetary Fund (IMF) publications. The first, “A Fair and Substantial Contribution by the Financial Sector,” is a report published in June 2010 at the request of the G-20. The second, “Taxing Financial Transactions: Issues and Evidence,” is a working paper published in March 2011 and authored by IMF economist Thornton Matheson.
Both papers point out that financial-sector bail-outs have cost taxpayers dearly, and will even once all the money is paid back. They also point out that the bailouts were highest where the markets were most “free.” In the UK, for example, the bailout debt stood at 6.1% of GDP at the end of 2009. In Germany, the figure was 4.8%, and in the United States it was 3.6%. As of January 2012, U.S. financial institutions bailed out under the Troubled Asset Relief Program (TARP) still owed the U.S. government more than $133 billion.
The papers first ask whether a major overhaul of the banking system is politically feasible and conclude that it’s not. They then move forward on the assumption that the current behemoth will one day run amok again, and the consequences will spill out to the economy as a whole, making another bailout inevitable. A tax, they conclude, should be looked at as part deterrent and part down-payment on the next debacle. They then take stock of all the various propositions on the table – from taxes on transactions to taxes on risky investments to taxes on liabilities.
The Obama Administration, for example, proposed a Financial Crisis Responsibility (FCR) fee, which would be a 0.15% tax on the liabilities of firms that received money under TARP. The FCR would be assessed on all companies until the last TARP money is paid back. The administration proposed the fee more than two years ago, however, and it hasn’t even been widely debated.
In the end, both papers advocate starting with sledge-hammers and working toward scalpels – specifically, with across-the-board taxes that evolve as regulators come to understand the specific sectors, companies and even individuals involved.
Fullerton advocates starting with a 0.25% tax on stock trades and a 0.02% on derivatives, but with exemptions for the first $100,000 of trades made by any individual each year, as well as pension funds and IRAs. This, he says, can be adjusted over time as regulators learn what works, what doesn’t and why.
“One thing I’m confident of is that none of the authors of any of these academic papers have any clue as to what’s going to happen,” he says. “Even the people who do high-frequency trading will have a hard time telling you what will happen, so how can some economist sitting in an office somewhere do the same?”
The history of FTT
Transaction taxes, it turns out, have a long tradition dating back to 1694, when Great Britain first implemented its “stamp duty” on trades at the London Stock Exchange. The U.S. imposed a financial transaction tax of $0.02 for every $100 of par value on all sales or transfers of stock. The rate doubled in 1932, but volumes were down with the Great Depression.
In 1936, John Maynard Keynes proposed ratcheting it up in his magnum opus, “The General Theory of Employment, Interest and Money.” Except for the flowery language, his reasoning could be something we’d hear today:
Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation.
These tendencies are a scarcely avoidable outcome of our having successfully organized "liquid" investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is compared with Wall Street to the average American, inaccessible and very expensive. The jobber’s “turn”, the high brokerage charges and the heavy transfer tax payable to the Exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the transactions characteristic of Wall Street. The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.
Roosevelt didn’t take him up on that, but the idea of using taxes to reduce speculation – as opposed to raising money – continued to kick around, even after the transaction tax was reduced to .004% in 1966 as a fee to keep the Securities and Exchange Commission.
When Bretton Woods came to an end in 1972, Nobel Laureate James Tobin proposed a transaction tax on currency transactions to prevent wild currency fluctuations. He reportedly admitted that his tax was technologically not feasible, but by 2009 Joseph Stiglitz was saying that a Tobin tax is both doable and desirable, but says it won't fly because transactions are difficult to measure.