At a meeting in Luxembourg last week, the finance ministers of 11 members of the European Union (Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain) agreed to support the proposal for the establishment of a financial transaction tax (FTT) across the Union.
But the road to implementing an FTT has been a rocky one. In fact, the European Commission (EC) had already adopted a proposal for a Council directive on a common system of FFT in September 2011. The idea, long supported by Germany and France, was opposed by other countries like the Netherlands, United Kingdom, and Sweden. The lack of unanimous support for the FTT was also recognised during Ecofin Council meetings in June and July this year.
Nevertheless, on 28 September, the European Commission put forward a proposal for a FTT and on 23 October the European Commission proposed to the EU Council to authorise the enhanced cooperation in the area of financial transaction tax. The Council will have to consult with the European Parliament before making a decision and eventually issuing a directive to implement the tax.
What the tax may look like
The European Commission hopes to achieve four main objectives: to raise more revenue for the Union’s budget; to ensure that the financial sector adequately contributes to tax revenues; to stabilise financial markets by discouraging high-frequency trades and speculation; and to strengthen of the internal market.
To achieve these goals, the original proposal of the European Commission suggested establishing a flat tax rate (e.g. 0.1% or 0.01% of the notional value) on the trading of financial instruments (shares and bonds) and derivatives thereof by financial institutions and all the enterprises conducting more than a certain threshold of financial activities.
With respect to the tax base, the European Commission’s proposal indicates that the inclusion of spot currency transactions are subject to its legal feasibility. Also, in order to reduce the impact of the tax on the cost of finance for companies, the primary markets for bonds and shares should be exempted.
If adopted, the tax will lead to an increase in the cost of each transaction, which will in turn lead to a reduction in the total volume of transactions of financial instruments and derivatives. The European Commission estimates that under certain scenarios, the reduction could be of as much as 70% of the current volume.
The amount of revenue generated by tax would depend on the actual reduction in transaction volumes as well as the tax rate imposed on each surviving transaction. For a tax rate of 0.01%, the EC estimates an inflow of revenues between 16.4 and 43.4 billion Euros. If the tax rate is set at 0.1%, then the expected inflow ranges from 73.3 to 433.9 billion Euros.
Pros and cons
The FTT has two main cons. First, finance will become more costly, especially for smaller firms that cannot access the primary markets for bonds and shares. The higher cost of finance may eventually trickle down and affect households.
Second, because of the increase in the cost of finance, investment will decrease and growth will slow down. Some European Commission estimates indicate that long-run GDP growth will be reduced by 1.7 percentage points a year if the tax rate is set at 0.1%. If instead the tax rate is set at 0.01%, then the slowdown in growth will be of only 0.16 percentage points.
A decline in growth is going to be particularly unpleasant at a time when fostering growth is the only way out of the debt crisis.
What, then, are the pros? Obviously, the increase in revenues is the immediate gain from the imposition of the tax. One can think of these revenues as a partial recovery of the cost of the financial crisis, or as a compensation for the tax advantage so far enjoyed by the banking sector. (Financial services are exempted from the VAT.) But these gains may be reduced, as financial institutions are able to pass the cost of the tax onto firms and households. The risk is that the FTT will ultimately add to the already heavy burden borne by European taxpayers.
The strongest potential gain from the FTT is the stabilisation of financial markets. The Nobel Prize winner James Tobin, who popularised the notion of a global tax on financial transactions (the so-called “Tobin Tax”), pointed out that short-term transactions are more likely to be destabilising than long-term transactions. With a flat tax rate, the effective tax rate on each transaction would be higher for transactions undertaken in shorter time horizons. Hence the tax would discourage short-term transactions and increase the proportion of long-term transactions, thus leading to less volatile financial markets.
Still, the empirical evidence indicates that things might not necessarily go as Tobin predicted (see, for instance, the survey of the UK Department for International Development). Higher transaction costs prevent price adjustment and lead to greater (not lower) volatility. In countries where transaction taxes were introduced in the past, price volatility hardly decreased and often increased. This was, for instance, the case of Sweden in the 1980s.
One way that financial institutions may respond to the FTT is by relocating their activities. This happened when Sweden introduced a round trip tax on equity transactions in 1984 and 1986. Most of the transactions happening in Stockholm ended up in London. It is therefore unsurprising to find the UK and Sweden among those who oppose the tax: they fear that the FTT would make their financial markets less competitive worldwide.
The FTT has clear merit, though — it has caused France and Germany to finally agree on something. It is a pity that what has been agreed upon is a medicine which may not do the patient too good.