EU Financial Transaction Tax Could Undermine Single Market
Sarah Jane Leake | Bloomberg Law
Last September, the European Commission published a proposal for a Directive introducing an EU-wide financial transaction tax (FTT) on certain transactions between financial institutions to take effect from 1 January 2014.1
The proposal has been generally welcomed by the European Parliament, mainly as a means to make the financial sector share some of the burden of the recent financial crisis, along with other sectors.2 However, once Parliament has taken a plenary vote on the proposal, which is scheduled to take place in June 2012, the proposal will then need to be agreed unanimously by all 27 Member States in the EU Council of Ministers.
The Alternative Investment Management Association (AIMA), the global representative of all practitioners in the alternative investment industry, argues that the proposed FTT would have “widespread, unintended damaging consequences.” In a recently published study3 (Report) on the likely impact of the proposed FTT, AIMA cautions that the tax could cause a significant slowdown in the cross-border trading of financial instruments in the EU and, in consequence, undermine the EU single market.
A charge to FTT would become payable on all transactions of bonds and shares at 0.1 percent, and on all derivatives transactions (regardless of whether they are exchange-traded or traded over-the-counter) at 0.01 percent where at least one party to the transaction is a financial institution and either that party, or another party to that transaction, is established within the EU. However, in order to preserve the free movement of capital, spot currency transactions would fall outside the scope of the tax.
A sizeable number of financial institutions would be directly affected by the FTT, including investment firms, credit institutions, insurance and reinsurance companies, collective investment undertakings and their managers, pension funds and their managers, holding companies, financial leasing companies, and special purposes entities. Central counterparties and securities depositaries, together with the European Financial Stability Fund, would not, however, be treated as a financial institution under the Directive.
— GDP Growth
While the Commission estimates that the proposed FTT could raise up to €43 billion in revenue each year, it also acknowledges that the tax could negatively impact on the EU’s GDP. The Commission itself forecasts that the FTT could reduce future GDP growth by up to 1.76 percent (i.e., up to €286 billion).4 If this is the case, overall tax revenues, argues AIMA, could also be reduced.
— Asset Price
Statistics show that higher transaction costs (which would include the FTT) are generally associated with lower asset prices. This is because an investor will require a higher return from securities that are associated with higher costs and, to this end, will bid the price down. The proposed FTT could therefore cause a significant reduction in asset prices.
Moreover, citing the International Monetary Fund (IMF), in its 2010 report to the G-20,5 AIMA argues that the shorter the average holding period of an asset, the greater the impact of the proposed FTT on the security’s value. The IMF predicts, for example, that a low FTT rate of 0.01 percent for short holding periods, such as one day, could cause a reduction in the security’s value to the tune of 50 percent. Conversely, for long holding periods, for example 10 years, a higher FTT rate of 0.5 percent is only likely to cause a 1.4 percent reduction. This would therefore provide investors with a strong incentive to hold stocks for longer periods. This, argues AIMA, would have a detrimental impact on the EU fund industry, since traders operating on a high turnover strategy and thin profit margins “could find that the tax adversely undermines the viability of their operations.”
— Market Liquidity
Higher transaction costs, caused by the Tobin-type tax, would therefore negatively affect profit margins for those dealing in equities, bonds, or derivatives. As a result, investors and traders would seek to reduce their turnover, as well as the total value of transactions. AIMA warns that this would, in consequence, cause a decrease in market liquidity and widen spreads.
By way of example, Sweden experienced a sharp drop in trading volumes in 1989 owing to the introduction of a security transaction tax on bonds up to 0.003 percent. During the first week, bond trading volume dropped by approximately 85 percent, trading in futures on bonds and bills fell by 98 percent, and trading in options virtually disappeared. Given that the tax rate proposed by the Commission is three to five times higher, its impact, cautions AIMA, would be “significantly worse” and could, in consequence, cause market volatility to increase.
— Employment Market
In line with current political sentiment, AIMA agrees that an EU-wide FTT would have a disproportionate effect in the UK. Given the scale of transactions undertaken in the City of London, compared to other cities within Europe,6 a broad-based tax on equities, bonds, and derivatives would cause the UK to contribute a sizeable portion of the tax. This has been estimated to amount to approximately 71 percent of the FTT,7 with, according to the Corporation of London, 80 percent of this sum being paid by London-based financial institutions.
The UK would therefore raise a significant portion of EU tax revenue, used primarily to support the EU budget, and reap little reward. “The success of the City of London in establishing itself as a centre for foreign exchange transactions stems,” argues AIMA, “from its regulatory and tax environment.” To add injury to insult, it has been forecast that the FTT would cost the City of London one out of every four jobs.8
— Transaction Migration
AIMA warns that the FTT could cause a transaction migration away from Europe to lower-taxed jurisdictions including New York, Singapore, and Hong Kong.
As liability to FTT would arise where at least one party to the financial transaction is located in the EU, a firm outside the EU that trades an EU equity, bond, or derivative with another non-EU party would be exempt from tax, even though a firm located in the EU would be taxed for trading in not only EU equities, bonds, and derivatives, but also international equities, bonds, and derivatives.
To AIMA, this tax-based residency principle is “inequitable.” It would provide a strong incentive for derivative broker/dealers to relocate to outside the EU. Other financial institutions would inevitably follow suit. AIMA expresses concern that the migration of transactions away from the EU “could possibly lead to a greater number of uncollateralised and weakly regulated transactions.”
According to the Commission’s own Impact Assessment, the volume of derivative transactions traded in the EU would decline by up to 90 percent, should the proposed FTT be introduced. This would be consistent with the decline in trading in Sweden in 1985, shortly after the introduction of a national FTT, where 60 percent of the trading volume of the most actively traded Swedish share classes migrated to London and 30 percent of all Swedish equity trading moved offshore (rising to 50 percent by 1990).
— EU Citizens
According to José Manuel Barroso, President of the Commission, EU taxpayers have “contributed more than €4,000 billion in guarantees to help the financial sector,” and “a transaction tax would serve to channel wealth from banks to society.” AIMA, however, disagrees. In its view, the proposed tax is likely to affect taxpayers adversely by reducing savings and retirement income at a time when the EU is still recovering from the financial crisis.” The burden of the tax,” it warns, “would be much greater than that contemplated.”
This is primarily due to the “cascading effect” of transaction taxes; in other words, the effect of taxes being applied to every constituent part of a particular trade. Under the Commission’s proposals, every time a share, bond, or derivative is purchased, transferred, or sold, liability to the proposed FTT would arise. This would have a debilitating effect on the EU single market, as cross-border trades inevitably involve longer transaction chains. For example, the various raw materials that comprise a final product, assembled in different parts of Europe, would be hedged by corporations in different Member States. The final product would therefore undergo payment of the proposed FTT many times over, through the hedging transactions undertaken by these corporations across the EU. In consequence, the cost of hedging, the cost of capital, and the price of the final product would all increase.
Unlikely to achieve its goals, the proposed FTT is instead expected to have serious negative repercussions on the EU single market. AIMA considers that the tax is liable to cause a significant reduction in asset price, reduce market liquidity, increase market volatility, bleaken employment levels, reduce the level of savings and investments of EU citizens, and encourage Europe’s financial institutions to relocate to lower-taxed shores. Moreover, it is likely to discourage long-termism, as investors would inevitably invest less in equities and more in riskier instruments, such as derivatives, owing to the bias in the proposed rates.
Given the controversy that the proposed FTT has sparked across the EU, it is likely that a number of Member States, in particular the UK, Sweden, the Czech Republic, and Bulgaria, will use their right to veto to block the implementation of this proposal. The UK Government has, for example, expressed strong views about the potential negative impact of an EU-wide FTT, and stressed that it would only support the idea if implemented at international level.9 To many, it is “incredible that we are discussing a financial transaction tax for 2014 when the Euro is burning.”10
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