Taxing the Financial Sector Avinash Persaud On Wednesday, 28 September, the European Commission (EC) proposed a European Union (EU)-wide 0.1% tax on bond and equity transactions and 0.01% on derivative transactions between financial firms to support European countries in crisis. This is not very dissimilar to the taxation in India on share transactions, but Cassandras in Europe and elsewhere will shout that it is another crazy idea from European leaders that will presage financial Armageddon, or at the very least, destroy liquidity, tax consumers not bankers and hinder the extension of finance to the poor and needy. In truth, this tax is more feasible than many would have us think, and like all taxes can be set well or badly and if set well, could bring several benefits. India too should widen its financial transactions tax (FTT) to include fixed-income and derivative instruments. Bankers would like us to think that you have to be a little crazy to support financial transactions taxes yet it is an idea with excellent pedigree. John Maynard Keynes proposed it in General Theory no less. Nobel laureate James Tobin followed suit in 1971 amid the wreckage of the Bretton Woods system of pegged but adjustable exchange rates. In 2009, the chairman of the United Kingdom

HT PAREKH FINANCE COLUMN

All taxes are an incentive for avoidance.

Taxing the Financial Sector

In addition to legal enforceability, FTTs need to be modest relative to the size of existing transaction costs and spread Avinash Persaud across as many substitutability instru

n Wednesday, 28 September, the European Commission (EC) proposed a European Union (EU)-wide 0.1% tax on bond and equity transactions and 0.01% on derivative transactions between ﬁnancial ﬁrms to support European countries in crisis. This is not very dissimilar to the taxation in India on share transactions, but Cassandras in Europe and elsewhere will shout that it is another crazy idea from European leaders that will presage ﬁnancial Armageddon, or at the very least, destroy liquidity, tax consumers not bankers and hinder the extension of ﬁnance to the poor and needy. In truth, this tax is more feasible than many would have us think, and like all taxes can be set well or badly and if set well, could bring several beneﬁts. India too should widen its ﬁnancial transactions tax (FTT) to include ﬁxed-income and derivative instruments.

Bankers would like us to think that you have to be a little crazy to support ﬁnancial transactions taxes yet it is an idea with excellent pedigree. John Maynard Keynes proposed it in General Theory no less. Nobel laureate James Tobin followed suit in 1971 amid the wreckage of the Bretton Woods system of pegged but adjustable exchange rates. In 2009, the chairman of the United Kingdom’s Financia l Services Authority, Adair Turner, caused consternation amongst London bankers by suggesting that it would be a good idea.

In between these proposals, bankers and politicians would preen their social consciences by saying that an FTT was a wonderful idea in theory, but that it just was not feasible. Financial markets, it was argued, had moved from iron controls over physical trading ﬂoors with ticker tapes and order sheets to cyber space, where, with a couple of clicks, trades can be routed to the ﬁnancial centre with the lowest transaction costs, taxes and regulation. It is a nice image and I know the argument well, as for a while I used to make it myself. Standing against this logic and perversely, standing against the UK government’s continuous riposte that it would only support a tax if it was global to limit avoidance, is the fact that one of the oldest and largest ﬁnancial transaction taxes, successfully functions on its own without global imitation, in one of the largest and most international ﬁnancial centres of the world – the UK.

UK Tax

Since 1986, and before in other guises, the UK government has unilaterally, without waiting for others to follow suit, levied a Stamp Duty Reserve Tax of 0.50% on transactions in UK equities. Despite not updating this tax to take into account derivatives and other innovations, or reducing its rate to improve competitiveness, it still raises $5 bn per year. The reason why this tax works and others, like the 0.50% transactions tax introduced in Sweden in 1984, did not, is that it is a stamp duty on the transfer of ownership and not based on tax residence. If the transfer has not been “stamped” and taxes paid, the transfer is not legally enforceable. Institutional investors who hold most assets around the world do not take risks with legal enforceability. Forty per cent of the UK Stamp Duty Reserve Tax receipts are paid by foreign residents. Far from sending taxpayers rushing for the exit, this tax gets more foreigners to pay it than any other.

London and Mumbai are not the only bustling ﬁnancial centre with a stamp tax on ﬁnancial transactions: Some of the most rapidly growing ﬁnancial centres in the world such as Hong Kong, Seoul, Johannesburg and Tapei, have ﬁnancial transaction taxes. Collectively, $20 bn per year is raised by these “unilateral” taxes. Even more revenues will be raised by new ﬁnancial transaction taxes announced in Brazil. Despite these taxes, Brazil struggles to calm overseas investor enthusiasm. In reality, sensibly, a one-off, 0.1% tax does not ﬁgure highly in the decision-making of long-term investors.

octoBER 8, 2011

ments as possible. There are advantages to simplicity, but on this basis the EC may wish to re-examine their proposal of the same rate on bonds and equities, as transaction costs are quite different for these different instruments. Clearing houses for ﬁnancial transactions between ﬁnancial ﬁrms have long made these distinctions in their fee structures without triggering distorting substitutions or causing confusion.

Having lost the feasibility argument, bankers have started to raise the liquidity argument – an evocative one so close to the ﬁnancial meltdown of 2008. The principal victim of transaction taxes are those engaged in very high frequency trading, as opposed to traditional pension funds, insurance companies and individual investors who turn over their portfolios less frequently. This is good news as it means that while bankers will try to pass on the tax to their customers, the brunt of the tax will not be paid by ordinary pensioners and savers, but hedge fund managers and investors. High-frequency traders argue that they provide critical liquidity to markets, but this is deceptive. During calm times, when markets are already liquid, high frequency traders are contrarian and support liquidity, but during times of crisis, they try to run ahead of the trend, draining liquidity just when it is needed most, as we saw with the Flash Crash, in New York, on 6 May 2010. If transaction taxes limit high-frequency trading it may even provide a bonus in improving systemic resilience.

India should join the EC, France, Brazil and others and back the extension of the FTT to a wider group of countries at the November G-20 meeting and argue that these international taxes, in which foreigners and locals pay alike, should, in part, fund international public goods, like peace and development.

Avinash Persaud (profadpersaud@gmail.com) heads the ﬁrm Intelligence Capital Limited and is Fellow of the London Business School.

vol xlvi no 41