The issues and the evidence
In recent months, various public policy groups, economists and politicians have advocated a tax on financial transactions. Proponents claim that such financial transaction taxes (FTTs) will raise revenues and discourage so-called “destabilising speculation.”
Opponents disagree and contend that FTTs are unlikely to achieve their stated goals, but would reduce market depth and liquidity, increase price volatility, put downward pressure on asset prices, hence raising corporate costs of capital, and precipitate flights of volume to jurisdictions that do not adopt the tax.
This article evaluates the likely economic consequences of FTTs using historical evidence as a guide. International experience to date generally indicates that FTTs are unlikely to generate the revenues promised by FTT proponents and yet are very likely to interfere (perhaps significantly) with the performance of the financial markets in allocating resources to their highest-valued uses. As such, policymakers in the Cayman Islands should resist the seeming allure of FTTs. The empirical evidence indicates that a FTT is more likely to wound or kill the local financial market than to be a public finance panacea.
Background on FTTs
Two current issues are acting as rallying cries for FTT proponents: (i) the claimed need to identify new sources of public finance to mitigate burgeoning fiscal deficits around the world2; and (ii) the widespread belief that “excessive speculation” should be reduced given its supposed role in causing or exacerbating the global credit crisis, notwithstanding the lack of hard evidence for that supposition. Numerous FTT proposals have been advanced around the globe in recent months based on these two mantras.
In the United States, for example, Congress is considering both the “Let Wall Street Pay for the Restoration of Main Street Act of 2009” (introduced by Rep. Peter DeFazio (D-OR) on 3 December, 2009) and the “Wall Street Fair Share Act” (introduced by Sen. Tom Harkin (D-IA) on 23 December 2009). The DeFazio plan would tax stock and equity option transactions at a rate of 0.25 per cent and derivatives transactions (eg futures, options, swaps, credit default swaps) at 0.02 per cent. The Harkin proposal would also tax stock transactions at 0.25% but would tax derivatives at a much higher rate of 0.25 per cent as well as taxing short-term debt at 0.02 per cent.
Such proposals are far from novel. FTTs have long been advocated as devices to raise public financing and attenuate financial activities viewed by some as “socially harmful”. In 1936, Lord Keynes, for example, advocated a tax on US equity transactions to reduce the influence of speculation on the US stock market, which he characterised as a casino.
Perhaps most famously, Nobel laureate James Tobin proposed a tax on foreign exchange transactions in 1978 for the purpose of “throw[ing] some sand in the well-greased wheels” of international currency markets in order to “moderate swings in international exchange rates” caused by what he perceived as excessive speculation3. Tobin’s proposed tax was not adopted, but numerous Tobin-like taxes have been subsequently proposed in the ensuing years – some of which have been adopted, as summarised in Table 1.
Rate periodically increased, reaching a maximum of 0.55%
Stock Purchases & Sales
Rate increased to 1% in 1986. Tax abolished in 1991.
Registration of Stocks/Convertibles
Stamp Tax – ongoing.
Fixed Income (Cash & Derivatives) Transactions
Tax abolished in 1990.
Stock Purchases & Sales
Rate increased to 0.6% in 1991. Rate reduced to 0.3% in
All Financial Transactions
Tax abolished in 2007.
Rate increased to 0.6% in 1999. Rate reduced to 0.3% in
Stock Purchases & Sales
Futures & Options Sales
Initial rate was 0.017%.
Foreign Investment in Stocks,
Foreign Currency Loans
ADRs of Brazilian Companies
Raising revenue and deterring speculation – irreconcilable differences
Despite the frequency with which FTT proposals have been advanced over the years, the empirical evidence is generally inconsistent with FTT supporters’ assertions that such taxes will raise significant revenues and quell speculation.
In order for a FTT to dampen speculation, the tax must lower the volume of short-term transactions. But any such reduction in trading volume simultaneously diminishes the revenue-generating potential of the FTT. The fundamental objectives of FTTs thus are inherently irreconcilable – viz., if the FTT rate is high enough to reduce speculation materially, the resulting reduction in trading volumes will significantly cut the expected revenues from the tax.
Empirical evidence suggests that the drop in trading volume precipitated by a FTT significantly shrinks actual FTT revenues vis-à-vis projections offered by FTT proponents. For example, bond trading volume in Sweden plummeted by about 85 per cent within one week of the imposition of a FTT (see Table 1). Trading in interest-rate futures also plunged by around 98 per cent. As a result, the tax raised only about three per cent of initial projected revenues.
FTTs, transaction costs and market liquidity
FTTs raise explicit trading costs by design, but the impact of FTTs on transaction costs does not stop there. Dealers and market makers that supply liquidity to financial markets are compensated for providing liquidity primarily through the bid/ask spread. Because FTTs raise the costs of offering liquidity, market makers respond to such increases in cost by widening bid/ask spreads. That, in turn, reduces market depth, potentially by significant amounts.
The relative impact of FTTs on trading volume depends largely on the size of the tax vis-à-vis other trading costs. But in that regard, even seemingly low tax rates can have a chilling effect on volume and liquidity. For example, a FTT of 0.02 per cent on derivatives transactions would increase the cost of trading a single CME Eurodollar futures contract (with a notional value of $1 million) from less than under $13 to more than $400, which the CME estimates could precipitate a catastrophic reduction in volume.
The capacity for FTTs to raise public revenues depends critically on whether the overall volume of trading falls or whether it simply shifts to venues and products not subject to taxation. If a FTT merely drives market participants into untaxed markets or products, the FTT will fail to generate significant revenue (or to reduce speculation).
Many financial transactions today can be executed in more than one market worldwide. A FTT imposed in one jurisdiction that is not simultaneously imposed in substantively the same form in other major financial centres will engender significant cross-border tax arbitrage. Empirical evidence from China, Finland, Japan, Sweden, Taiwan and other countries confirms that trading migrates (quickly) to lower-tax jurisdictions following the introduction of FTTs. Conversely, reductions in FTT rates have typically been associated with subsequent increases in trading volume.
That uncoordinated and unilateral FTTs divert financial transactions offshore has been widely noted. Indeed, a number of European countries have approved FTTs but have conditioned implementation on adoption of a similar tax by all European Union members. Although German Chancellor Angela Merkel was a strong proponent of a FTT initially, as recently as July 19th a top expert in her ruling party said that Germany will not introduce a FTT without international coordination.
The problem, of course, is that in today’s technologically interconnected global marketplace, some jurisdiction can be expected not to adopt a FTT either based on the costs of FTTs or a strategic effort to attract tax-arbitrage-induced trading. Either way, the idea of a “global coordinated FTT” is naïve and illusory.
Tax arbitrage, moreover, need not be cross-border. It also occurs across different financial products within the same jurisdiction. In the United Kingdom, for example, the stamp tax on transfers of ownership of securities (see Table 1) has fostered the development of an active market in off-exchange derivatives called “contracts for differences” that replicate the cash flows of the underlying securities without transferring ownership (and hence without triggering the tax).
No matter how granularly a FTT proposal tries to tax different financial products, the history of financial innovation demonstrates the futility of that endeavour. Most financial product innovations occur in response to unexpected changes in taxes and regulations4. As such, FTTs will surely give rise to new financial products designed to be just beyond the reach of politicians and tax authorities.
FTTs and price volatility
Proponents claim that a major goal of FTTs is the reduction in the volatility of asset prices, which they contend will improve the informational efficiency of financial markets.
“Volatility” means different things to different people. To academics, volatility typically refers to the variability of asset prices or returns. To others, volatility often refers either to the speed with which financial markets respond to new information or to the potential for prices to overshoot price levels commensurate with economic fundamentals. Regardless of one’s definition of volatility, the empirical evidence does not generally support the view that FTTs reduce volatility.
Most empirical research indicates that FTTs either have no effect on price variability or that increases (decreases) in FTT rates are followed by increases (decreases) in price variability. Studies of changes in FTT rates in China, Finland, Greece, Sweden, Taiwan, the United Kingdom and elsewhere all generally demonstrate that the decrease in market depth and liquidity resulting from higher FTT rates more than offsets the factors that might reduce volatility. Studies of the impact of other changes in transaction costs in the financial markets of countries like France, India and the United States further indicate that increased transactions costs tend to increase price variability.
Similarly, various economic studies indicate that FTTs slow the speed with which prices adjust to new information. Ironically, that may benefit certain speculators by increasing opportunities to trade at less-informative and stickier prices.
Yet another meaning of volatility is the supposed overshooting of market prices relative to levels dictated by economic fundamentals. The question of whether speculators are disrupting commodity markets and are responsible for the large price swings that many commodities have experienced in recent years, for example, has been the subject of considerable dispute and analysis. Although there is no consensus about the role of speculation on changes in commodity prices, numerous recent economic studies have concluded that speculative trading is not responsible for these swings. For example, a variety of studies stress that many non-exchange-traded commodities that are unaffected by speculation have experienced price swings as large as those observed for exchange-traded commodities in which speculators play a significant role.
FTTs, asset prices and the cost of capital for corporations
Some contend that a FTT will increase average asset prices by reducing excess volatility that in turn may increase the risk premium investors demand to hold securities. The counter-argument is that the higher costs of transactions inclusive of a FTT will drive up investors’ required rates of return and thus depress asset prices.
The empirical evidence indicates that even a modest FTT could result in substantial declines in asset values, which in turn increases the cost of raising capital for corporate security issuers. Studies of the impact of FTTs in Japan, the United Kingdom, Sweden and a variety of other countries indicate that imposition of FTTs (and/or increases of FTT rates) were associated with declines in asset prices.
The economic literature on FTTs and the historical record indicate that many of the claims made by proponents of such taxes are not supported by the available evidence. FTTs are unlikely to generate the revenues ballyhooed by FTT advocates, but are likely to interfere with the performance of financial markets. By reducing trading volume and associated trading and clearing fees, moreover, FTTs may also undermine the financial strength and international competitiveness of organised exchanges in jurisdictions where the FTTs are imposed.