In late September 2011, the European Commission launched a proposal for the introduction of a financial transaction tax (FTT) in the European Union. This tax would be levied on the purchase and sale of nearly all securities, including shares, debt securities and derivatives. The rate on shares and debt securities would be 0.1% and on derivatives 0.01%.
With the FTT, the Commission aims to discourage risky trading (including speculation) and to make the financial sector pay for part of the damage caused by the crisis. However, it is doubtful whether the proposal will in fact realise those goals, whereas the negative impact on the economy is a certainty. The Netherlands will be affected relatively severely by an FTT on account of its large financial sector, including pension funds. The negative effects in terms of economic growth and arbitrage will be stronger, moreover, if tax is not levied on a global scale. Therefore the introduction of an FTT as proposed by the Commission is undesirable.
It is questionable whether an FTT would be successful in counteracting speculation and other undesirable market behaviour, thus enhancing financial stability. While an FTT might for instance counteract forms of arbitrage, such as high-frequency trading, it may also cause traders to relocate or to increase their risk appetite. Pursuing a riskier trading strategy to protect one’s margins would run exactly counter to what the Commission’s proposal aims to achieve. Which of the two possible effects would win out is unpredictable. Moreover, it is questionable that an FTT would be effective in counteracting market volatility – which is one of the frequently cited benefits of an FTT.
Moreover, the Commission’s draft proposal raises several questions. The lower rate on derivatives compared to shares may provoke arbitrage and intransparent financial innovations. Secondly, it is uncertain what the per-transaction rate will turn out to be. Since the tax also applies to intermediaries in a transaction, the result may be a ‘cascade effect’ that will multiply the taxation rate. Thirdly, the effects of the FTT will include implications for the repo market, currently a major source of short-term funding for banks. To sum up, hard evidence that the FTT would yield a net stabilising effect is lacking.
The Netherlands, with its relatively large financial sector, will contribute a relatively high share of the EUR 57 billion in revenue which the Commission expects the FTT to bring in. The FTT does not distinguish between speculative and normal market behaviour, and much of the revenue would come from banks and pension funds. Early estimates of DNB suggest that the tax will touch Dutch banks, pension funds and insurers at the rate of some EUR 4.0 billion per annum. Of this amount, some EUR 2.0 billion will come from the banks, EUR 1.7 billion from pension funds and EUR 0.3 billion from insurance companies. For banks, most of the hurt will come from the trade in shares and debt securities, whereas pension funds conclude relatively many derivatives contracts. The FTT’s total yield in the Netherlands will be higher, given the burden on other sectors not included in the estimate (such as investment firms).
The impact study was based upon the following assumptions. First and foremost, the FTT was assumed to cause behavioural effects, driving down trading volumes. DNB’s estimate of this effect is lower than that of the Commission, because pension funds, in particular, use derivatives to hedge against interest rate risks. If, as a result of the FTT, pension funds reduce the number of derivatives contracts, the net risk may increase, which would be undesirable. The costs involved in the FTT will eventually translate into higher costs for the clients of financial institutions, who include pension fund members and borrowers.
An FTT will slow down economic activity as it increases the cost of capital and encourages evasive behaviour. An FTT on equity and debt securities trades will increase the cost of capital, since holders will demand higher yield to offset the tax. A higher cost of capital reduces investments, thereby slowing down economic growth. The available impact studies, including those of the Commission and of the Netherlands Bureau for Economic Policy Analysis (CPB), indicate that the costs involved in an FTT will lie in the same order of magnitude as its yield.
The tradeoff between potentially favourable behavioural effects and the adverse impact on the economy will be more pointed if the tax is not introduced on a global scale. A tax that is introduced unilaterally in the European Union may be evaded by moving business operations out of the EU. Thus the FTT may act as a barrier for foreign parties to establish themselves or do business here. The negative effects would be further reinforced if the tax were introduced in only part of the EU, such as the eurozone. This would create even more opportunities for tax evasion and arbitrage. So it will be better to take measures that directly target potentially deleterious forms of financial trading. Should the FTT prove inevitable, then global introduction is to be preferred, since it will provide an international level playing field and significantly limit the associated economic costs.