The Financial Transaction Tax - It Is Wrong In So Many Ways

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The European Parliament’s Economic and Monetary Affairs Committee (ECON) has agreed to move forward on a report proposing a pan European Financial Transaction Tax (FTT).

Details are scheduled to appear early next year as the Commission develops the draft legislation based on ‘enhanced cooperation’ between members. It is anticipated to reflect a September 2011 proposal and the French FTT which came into effect in August and taxes equity transactions at 0.1% and derivatives at 0.01%.

It is hard to know where to start in highlighting the idiocy of this proposal: It is so wrong in so many ways.

Firstly it looks likely to be set too high. An FTT which users hardly notice might have some merit. It could raise moderate revenues without damaging the market. However the politicians appear to want to raise significant sums with some notion of repairing damaged sovereign balance sheets. Anything that ambitious will create ripple effects with adverse implications for the underlying markets and the European economy overall.

It is promoted as a tax on banks and other institutions which 'caused' the financial crisis. However, to the extent it can be collected, it will be paid by the end users. Banks and other market makers need a certain return on market-making activities for them to be worth the risk. At the margins, players constantly enter and leave the market, or ramp up or reduce their commitment, depending on the profitability. It is highly competitive. Yes, some players make vast sums. However others make losses.

The risk and returns set the overall pricing players in the market expect. The margins are currently wafer thin. The only way additional costs, such as a tax, can be absorbed is by passing them on to clients. Those clients include pension and insurance fund managers who invest in equities and the same fund managers plus corporates who use derivatives to hedge risks. Is that really what the FTT proponents want to achieve – reduced pensions for EU citizens ?

However that may in fact be somewhat irrelevant, because it assumes the market continues to use the instruments taxed and to transact in the jurisdictions where it is applied. Recent data suggests that institutional investors in France are already migrating to instruments, such as single-stock futures, on which the tax does not apply. Another response is to stop the activity altogether. Many buy-side firms have stopped offering market tracking corporate bond funds because there simply is not the liquidity to allow them to manage the weightings.

This is in large part due to the impact of recent regulatory change on the ability of banks to hold corporate bond inventory whereby they can make markets in these instruments – an unintended consequence of the regulations. An unintended consequence of the FTT (and other regulatory changes) is likely to be that companies simply stop using the instruments. Fund managers stop including them in their investment and hedging strategies and or stop offering the products which use them. Corporates simply leave their balance sheet risks unhedged. The result, less choice, less business, more risk.

Perhaps the most obvious unintended consequence is that the business simply migrates to jurisdictions which do not charge the tax. Admittedly this will be limited by applying the tax on the end user – the client. This, while also making it more clearly a cost to the end user, will certainly make it harder to avoid. However, that assumes the clients hang around. It will be yet another incentive on those companies which can, to remove their trading and hedging activities from the European jurisdiction altogether. Anyone in Europe who thinks there are not plenty of other centres just waiting to welcome our businesses with open arms and lower tax regimes is deluded. It is unlikely the FTT alone will make companies move, but the impacts are cumulative and add to the many other incentives to leave today’s increasingly over-regulated and high cost Europe.

A nominal tax might work, but will not generate the desired returns. However a high tax, in a world of globalised markets, is almost certain not to generate the desired returns either. On the other hand it will reduce the pensions of Europe’s citizens and damage the ability of corporates and institutions to hedge their risk. It will discourage market participants from using the most suitable instruments and it will add to incentives on entities to re-locate outside of Europe. As a result it will damage economic activity and reduce the overall tax take of member states – almost certainly by more than the FTT itself raises. What a great idea. Is the short term political attraction really worth the risk of all that ?

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