The Financial Transaction Tax (FTT), which is to be adopted in 2014 by 11 eurozone countries, has come under a lot of flak lately.
Most recently, Sir Mervyn King said he could not “find anyone in the central banking community who thinks it’s a good idea.”
Even the Italian government, initially committed to adopting an FTT, is now having second thoughts — particularly because the tax will affect secondary trading in government bonds.
An FTT might have unpleasant unintended consequences, damaging economic growth on the European continent and beyond.
In stark contrast, Algirdas Šemeta, the European Commissioner for taxes, claims that the levy of 0.1% on equity and fixed income transactions and 0.01% on derivatives is a response “to the persistent demands of their citizens, who have long called for a harmonized FTT in Europe. The levy will ensure that the under-taxed financial sector finally makes a fair contribution to the public purse.”
Besides generating significant new revenues to cash-strapped European governments, “it should help to deter the irresponsible financial trading that contributed to the crisis we are in today,” says Mr. Semeta.
However, there is very little rationale for such claims.
If adopted, an FTT will not be a boon for public budgets — nor is it likely to prevent financial crises. Instead, it might have unpleasant unintended consequences, damaging economic growth on the European continent and beyond.
The proponents of the tax argue that an FTT will reduce speculative and irresponsible trading, which was allegedly behind both the financial crisis of 2008 and the sovereign crisis in Europe.
But even if one believes that the ability to trade instantly, at practically zero cost, has helped to spread the panic, an FTT is not going to help.
There is no evidence that an FTT would moderate market volatility — and attenuate sudden shifts of mood on financial markets.
A recent report by Anna Pomeranets from the Bank of Canada concluded that there have been instances when an FTT led to an increase in volatility — most significantly on the New York Stock Exchange and the American Stock Exchange, between 1932 and 1981, where increases in the FTT were associated with rising volatility, increased bid-ask spreads, and lower trading volumes.
Similarly, the idea that capital is under-taxed in current tax regimes is mistaken.
If anything, tax systems that rely on the taxation of income tend to tax savings more heavily than consumption.
An additional levy on financial transactions will further discourage individuals and firms from saving and investing. And because financial capital is among the most mobile factors of production, expect this effect to be strong — leading both to less investment and therefore lower productivity and less growth in Europe.
That investment is highly sensitive to taxation means that the tax is unlikely to yield much revenue either.
Because an FTT is applied to all transactions made with a given security, its effect is cumulative — hence the deceptiveness of the seemingly low tax rates.
But that means that its application will change the nature and frequency of financial transactions, leading to lower tax revenues than anticipated by its advocates.
Sweden’s Bad Example
After an FTT was introduced in Sweden in 1984, trading in long-term bonds declined by 85% and practically half of all the trading in Swedish stocks moved to non-Swedish markets.
The EU’s FTT directive tries to remedy this problem by being set up as an extraterritorial tax.
The transfer of any security will be taxed even if it takes places outside of the relevant jurisdiction, as long as the security is issued in the country that applies the FTT (the issuance principle) or if the investor is residing in the country that applies the FTT (the residence principle).
Such a solution, though, is much worse than the problem it purports to address.
Extraterritoriality is legally contentious.
The United Kingdom has already launched a legal challenge at the European Court of Justice, on the grounds that it harms countries that are not taking part in implementing it.
Legal issues aside, an extraterritorial tax is an attack on tax competition, reducing the incentives of governments that are not taking part in an FTT to improve their tax and institutional environments in order to attract capital flows.
Worse yet, an FTT may lead investors to leave Europe altogether, and invest and issue securities in friendlier jurisdictions.
The real losers in that process will be the citizens of the 11 European countries who signed up for this fool’s errand — including relatively poor economies such as Slovakia, Slovenia or Estonia.