The Financial Transaction Tax Nightmare

With austerity an almost permanent feature of most EU countries, budget deficits reduced but not necessarily tamed, bankers still being equated to vampire squids or worse and the perfidious Albion seeking to protect the denizens of the City in their EU treaty renegotiation demands, a tax on financial services should strike a rare unifying chord with voters across the divided continent and help the popularity ratings of their political masters.

With austerity an almost permanent feature of most EU countries, budget deficits reduced but not necessarily tamed, bankers still being equated to vampire squids or worse and the perfidious Albion seeking to protect the denizens of the City in their EU treaty renegotiation demands, a tax on financial services should strike a rare unifying chord with voters across the divided continent and help the popularity ratings of their political masters.

The EU is moving ahead, at least partially, with its plans for a Financial Transaction Tax. In the eyes of the 11 proponents of this tax, it has a dual attraction. There is a belief that it could be a substantial tax source. There is also an enthusiasm for its deterrent effect, the latest weapon to dampen down speculation in markets. The aim of the participants is to make the tax as far reaching as possible. It would have too many escape hatches if it were simply collected in the impacted countries. On the one hand, there are derivatives that can mirror securities or depository receipts that can represent them. There is a chance that offshoring, especially in London, Zurich and more remote financial centers, could provide a safe haven. Then there are contracts for difference that could become trading substitutes. So how is it all going to work?

One thing is certain. The barriers that are being planned will be simpler to define than to implement. If we look at the longstanding U.K. Stamp Duty on shares, collection is simple in the U.K. market where the CREST settlement system partners the U.K. tax authorities to enable collection of the multi-billion euro tax take from the half-a-percent levy on all domestic company equity transactions. There is a mechanism to enable U.K. shares to be held in depository form; the major ICSDs have arrangements in place to ensure compliance, and the system works. But it would be illusory to assume that it is watertight.

First of all, internalized trades create a loophole. Second, there are overseas transactions that may well escape the rigors of the U.K. rules. And finally, the collection mechanism for depository receipts and like structures is based on pragmatic guesswork rather than scientific exactitude. Importantly, for that ensures continued liquidity of U.K. equities, market makers are exempted from the tax on their principal trades. And taxing equities is simplest of all, for the home country dominates their issuance and the home issuer selects, in most cases, how they are handled in offshore structures.

The main trouble with the EU proposal is three-fold. First, the administration is unclear. Secondly, liquidity impacts have been ignored. And thirdly, the planned tax covers equities, bonds and many derivatives.

The problem with selecting a wide range of instruments is that we are in new territory. It is relatively simple to capture transactions in the home countries of the tax. The clearing system or the central securities depositories can be required by law to be agent for the local tax authorities to centralize administration. Alternatively, but with a heavy administrative burden, investors could be required to make the appropriate returns. The problem arises when we come to issues of extraterritoriality. How does one identify every trade in every country where a transaction could occur? The process is simple for equities, but much more difficult for bonds and quite mind-boggling for many derivative instruments. Who monitors the transaction volumes? Who collects the tax? Who decides who or what is exempt? And who moves fast enough to close the loopholes that every competent vampire squid will invent?

The liquidity impact of the process has also been ignored. It appears that no one in authority believes that the new rules will affect process. That is illusory as, at a minimum, the price of a taxed instrument will be adjusted to compensate for the increased cost of ownership relative to its peers. And, if speculative trading is reduced, any analysis points to wider spreads in lower volumes. The current assessments of the reduction in trading volumes and the impact on price is based on guestimates, but, given the planned reach of FTT into all sides and types of transaction, it will be meaningful in the EU countries involved.

Lower activity will also lead to less employment, and, although most stories are exaggerated, we need to only look at the fall in U.K. tax take from the declining and now often-deferred City bonus pools to realize that this is part of the downside for the authorities. The billions of euros of windfall tax will need to be netted against the higher cost of government (and private sector) funding and the reduction in taxes from the financial sector.

The real politic is that the tax is likely to be marginal to self-destructive unless the aging Tobin principles are adopted on a worldwide basis. It is worth noting that few markets have more than a dozen leading shares that dominate their exchanges. Could these often global companies redomicile? I doubt any would do it just to escape FTT. But some global banks may be exceptions to that rule!

And, as my old firm, HSBC, showed in the early 1990s, it is easy to redomicile a major company. Just as in equity markets, a few instruments account for the bulk of trading in bonds and derivatives as well; the potential for imaginative reengineering to avoid FTT in those segments is high. That will bring with it the risk of scope creep in the rules. As bond and currency surrogates are developed outside the initial likely reach of the rules, the temptation will be to add to the rulebook.

This is a nightmare waiting to happen. There is much justification to be said for countries to levy more taxes on their financial sector, for they have proved a heavy burden to their taxpayers. The implicit guarantee given to the banking sector definitely comes cheap and could be a case in point. But FTT appears to be already an over-complex, cross-jurisdictional, administratively challenging exercise with likely little et value to the different exchequers and national economies.

Without global consensus, the tax does not work, and it will only be effective if kept simple. I was once privy to a dispute about stamp duties on U.K. shares. The case lasted years. Given the relative complexity of the current FTT proposal, I suspect it has to be supported by at least one sector. The lawyers will undoubtedly be better off if the current moves ever come to fruition.

 

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