The ‘Tobin tax’ has once again appeared in the headlines having been proposed by the European Commission and opposed by the US. This column argues that such taxes are more feasible than most think when they are linked to legal enforceability, and that the burden would be disproportionately borne by high-frequency traders that provide liquidity only when the markets don’t really need it.
The announcement on Wednesday that the European Commission will propose an EU-wide, 0.1% tax on bond and equity transactions, and 0.01% on derivative transactions between financial firms, to support European countries in crisis, will generate substantial opposition. Cassandras will shout that it is another crazy idea from Europe that will presage financial Armageddon.
In truth, this tax is more feasible than many would have us think, and like all taxes can be set well or badly and if set well, could bring several benefits.
Old wisdom: Maybe good but infeasible
Before the Commission’s announcement, bankers and politicians would preen their social consciences by saying that a financial transaction tax was a wonderful idea in theory, but that it just wasn’t feasible. Financial markets, it was argued, had moved from iron controls over physical trading floors with ticker tapes and order sheets to cyber space, where, with a couple of clicks trades can be routed to the financial centre with the lowest transaction costs, taxes, and regulation. It’s a nice image and I know the argument well as for a while I used to use it myself.
Standing against this logic – and, perversely, against the UK government’s continuous riposte that it would only support a tax if it was global to limit avoidance – is the fact that one of the oldest and largest financial transaction taxes successfully functions on its own without global imitation. And it does this in one of the largest and most international financial centres of the world – the UK.
Since 1986, and before in other guises, the UK government has unilaterally, without waiting on others, levied a Stamp Duty Reserve Tax of 0.50% on transactions in UK equities. Despite not updating this tax to take into account derivatives and other innovations, or reducing it to improve competitiveness, it still raises $5 billion per year.
The reason why this tax works and others, like the 0.5% transactions tax introduced in Sweden in 1984, did not, is that it is a stamp duty on the transfer of ownership and not based on tax residence. If the transfer has not been ‘stamped’ and taxes paid, the transfer is not legally enforceable. Institutional investors who hold most assets around the world do not take risks with legal enforceability. Forty percent of the UK Stamp Duty Reserve Tax receipts are paid by foreign residents. Far from sending taxpayers abroad, this tax gets foreigners to pay.
London is not the only example
The UK is not the only bustling financial centre with a stamp tax on financial transactions. Some of the most rapidly growing financial centres in the world such as Hong Kong, Seoul, Mumbai, Johannesburg, and Taipei, have long had financial transaction taxes and today these countries raise $20 billion per year on these ‘unilateral’ taxes. Even more revenues will be raised by new taxes in Brazil, which, despite these taxes, is struggling to calm investor enthusiasm. A one-off, 0.1% tax doesn’t figure highly in the decision-making of long-term investors.
All taxes are an incentive for avoidance. In addition to legal enforceability, financial transaction taxes need to be modest relative to the size of existing transaction costs and spread across as many substitutability instruments as possible. There are advantages to simplicity, but on this basis the European Commission may wish to re-examine their proposal of the same rate on bonds and equities as transaction costs are quite different for these different instruments. Clearinghouses for financial transactions between financial firms have long made these distinctions in their fee structures without triggering distorting substitutions or causing confusion.
Having lost the feasibility argument, bankers have started to raise the liquidity argument – an evocative point when we are still so close to the financial meltdown of 2008.
The principal victim of transaction taxes are those engaged in very high-frequency trading, as opposed to traditional pension funds, insurance companies and individual investors who turn over their portfolios less frequently. This is good news as it means that while bankers will try to pass on the tax to their customers, the brunt of the tax will not be paid by ordinary pensioners and savers but hedge fund managers and investors.
High-frequency traders argue that they provide critical liquidity to markets, but this is deceptive. During calm times, when markets are already liquid, high-frequency traders are contrarian and support liquidity, but during times of crisis, they try to run ahead of the trend, draining liquidity just when it is needed most, as we saw with the Flash Crash on 6 May 2010. If a transaction tax limits high-frequency trading it may even provide a bonus in improving systemic resilience.