The over­selling of Fi­nan­cial Trans­ac­tion Tax

Financial Mirror (Cyprus) - - FRONT PAGE -

How­ever Novem­ber’s pres­i­den­tial election in the United States turns out, one pro­posal that will likely live on is the in­tro­duc­tion of a fi­nan­cial trans­ac­tion tax (FTT). While by no means a crazy idea, an FTT is hardly the panacea that its hard-left ad­vo­cates hold it out to be. It is cer­tainly a poor sub­sti­tute for deeper tax re­form aimed at mak­ing the sys­tem sim­pler, more trans­par­ent, and more pro­gres­sive.

As Amer­i­can so­ci­ety ages and do­mes­tic in­equal­ity wors­ens, and as­sum­ing that in­ter­est rates on the na­tional debt even­tu­ally rise, taxes will need to go up, ur­gently on the wealthy but some day on the mid­dle class. There is no magic wand, and the po­lit­i­cally ex­pe­di­ent idea of a “Robin Hood” tax on trad­ing is be­ing badly over­sold.

True, a num­ber of ad­vanced coun­tries al­ready use FTTs of one sort or an­other. The United King­dom has had a “stamp tax” on stock sales for cen­turies, and the US had one from 1914 to 1964. The Euro­pean Union has a con­tro­ver­sial plan on the draw­ing boards that would tax a much broader ar­ray of trans­ac­tions.

The pres­i­den­tial cam­paign of US Sen­a­tor Bernie San­ders, which dom­i­nates the in­tel­lec­tual de­bate in the Demo­cratic Party, has ar­gued for a broad-based tax cov­er­ing stocks, bonds, and de­riv­a­tives (which in­clude a vast ar­ray of more com­plex in­stru­ments such as op­tions and swaps). The claim is that such a tax will help re­press the forces that led to the fi­nan­cial cri­sis, raise a sur­real amount of rev­enue to pay for pro­gres­sive causes, and barely im­pact mid­dle-class tax­pay­ers.

So far, Hil­lary Clin­ton, the likely Demo­cratic nom­i­nee, has em­braced a nar­rower ver­sion that would tar­get mainly high­speed traders, who ac­count for a large per­cent­age of all stock trans­ac­tions, and whose con­tri­bu­tion to so­cial wel­fare is open to ques­tion. Clin­ton, how­ever, may well shift closer to San­ders’s po­si­tion over time, as she has on other is­sues. Don­ald Trump, the pre­sump­tive Repub­li­can nom­i­nee, has not yet ar­tic­u­lated a co­her­ent po­si­tion on the topic, but his views of­ten come down re­mark­ably close to those of San­ders.

The idea of tax­ing fi­nan­cial trans­ac­tions dates back to John May­nard Keynes in the 1930s and was taken up by Yale pro­fes­sor and No­bel lau­re­ate James Tobin (who, in­ci­den­tally, was my un­der­grad­u­ate pro­fes­sor) in the 1970s. The idea, in Tobin’s words, was to “throw sand in the wheels” of fi­nan­cial mar­kets to slow them down and make them hew more closely to eco­nomic fun­da­men­tals.

Un­for­tu­nately, this ra­tio­nale has not held up par­tic­u­larly well ei­ther in the­ory or in prac­tice. Par­tic­u­larly mis­guided is the idea that FTTs would have sig­nif­i­cantly muted the buildup to the 2008 fi­nan­cial cri­sis. Cen­turies of ex­pe­ri­ence with fi­nan­cial crises, in­clud­ing in coun­tries with FTTs, strongly sug­gests oth­er­wise. What is re­ally needed is bet­ter reg­u­la­tion of fi­nan­cial mar­kets. The un­wieldy and deeply im­per­fect 2010 Dodd Frank leg­is­la­tion, with its thou­sands of pages of pro­vi­sions, is a stop­gap mea­sure; few se­ri­ous peo­ple view it as a long-term so­lu­tion. A far bet­ter idea is to force fi­nan­cial firms to is­sue much more eq­uity (stock), as Stan­ford Univer­sity’s Anat Ad­mati has pro­posed.

The more banks are forced to eval­u­ate risks based on share­holder losses rather than govern­ment bailouts, the safer the sys­tem will be. (On this score, Bos­ton Univer­sity pro­fes­sor Lau­rence Kot­likoff’s more rad­i­cal ideas for tak­ing lever­age out of the fi­nan­cial sys­tem merit se­ri­ous at­ten­tion, even if his own quixotic pres­i­den­tial cam­paign oth­er­wise goes un­no­ticed).

The fun­da­men­tal prob­lem with FTTs is that they are dis­tor­tionary; for ex­am­ple, by driv­ing down stock prices, they make rais­ing cap­i­tal more ex­pen­sive for firms. In the long run, this low­ers labour pro­duc­tiv­ity and wage lev­els. True, all taxes are dis­tort­ing, and the govern­ment has to raise money some­how. Yet econ­o­mists view FTTs as par­tic­u­larly trou­ble­some be­cause they dis­tort in­ter­me­di­ate ac­tiv­ity, which am­pli­fies their ef­fects. A mod­est tax that is nar­rowly tar­geted, like the UK’s, does not seem to cause much harm; but the rev­enue is mod­est.

To get more rev­enue re­quires cast­ing the net much wider. For this rea­son, the San­ders plan cov­ers de­riv­a­tive in­stru­ments that would cir­cum­vent the FTT (for ex­am­ple, by al­low­ing peo­ple to trade in­come streams on as­sets with­out trad­ing own­er­ship). But ex­tend­ing the tax to de­riv­a­tives is a messy busi­ness, be­cause their com­plex­i­ties make it dif­fi­cult to de­fine pre­cisely what should be taxed. And as the im­pact of the tax expands, it be­comes hard to know what the ul­ti­mate ef­fects on the real econ­omy will be.

It is cer­tainly dif­fi­cult to de­ter­mine whether the out­size rev­enue es­ti­mates of the San­ders cam­paign could be re­alised; many stud­ies sug­gest oth­er­wise. The claim is that the US can col­lect more than five times the amount the UK col­lects on its nar­row tax – an amount equal to more than 10% of rev­enue from per­sonal in­come tax. The prob­lem is that trad­ing will likely col­lapse in many ar­eas, and many fi­nan­cial trades will be ex­e­cuted in other coun­tries. If eco­nomic growth is af­fected, even­tu­ally other tax rev­enues will fall, and if govern­ment bonds are cov­ered, bor­row­ing costs will rise.

The US des­per­ately needs com­pre­hen­sive tax re­form, ide­ally a pro­gres­sive tax on con­sump­tion. In any case, a prop­erly de­signed FTT can be no more than a small part of a much larger strat­egy, whether for re­form­ing the tax sys­tem or for reg­u­lat­ing fi­nan­cial mar­kets.

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