A Financial Transactions Tax: Inefficient or Needed Systemic Reform?
Buckle, Ross P., North, Gill, Georgetown Journal of International Law
TABLE OF CONTENTS I. INTRODUCTION II. FINANCIAL MARKET TRADING--THE FACTS III. PROPONENTS OF A FINANCIAL TRANSACTION TAX (FTT) IV. EUROPEAN COMMISSION REPORT V. IMF REPORTS A. A Fair and Substantial Contribution by the Financial Sector: IMF Staff Final Report for the G-20 B. IMF Working Paper: Taxing Financial Transactions: Issues and Evidence 1. Asset Valuation and Cost of Capital 2. Turnover 3. Liquidity 4. Price Discovery 5. Volatility i. Short-Term Volatility ii. Longer-Term Volatility 6. Waste 7. Matheson Conclusions 8. Our Response to the Report Findings VI. THE ADMINISTRATIVE FEASIBILITY OF AN FTT 1. Territorial Scope 2. Taxable Event 3. Tax Base 4. Taxable Person 5. Assessment & Collection of the Tax VII. RECENT FTT DEVELOPMENTS VIII. CONCLUSION
The global financial crisis (GFC) sparked vigorous debate on the role of financial institutions and capital markets, and the extent to which financial institutions and other capital market participants should contribute to the broader economy. Much of this debate has centred on the appropriate mechanisms to enable governments to recoup taxpayer monies used to bail out failing institutions and appropriate tax regimes going forward. Proposals considered at an international level have included financial institution levies (such as a financial stability contribution), a financial activities tax (FAT) and a financial transaction tax (FTT) (sometimes referred to as a securities transaction tax). France, Germany, the United Kingdom (UK), and other countries have already imposed levies on their financial industries to recoup bailout funds provided in the GFC, boost government revenues, and build a fund to help meet the cost of future crises. (1) This Article focuses on an FTT as a needed addition, or alternative to, bank levies. (2)
Critics of an FTT argue that a tax would have distorting effects on the function of the market and harm its efficiency due to reduced liquidity, higher volatility, and increased capital costs. (3) Those who support an FTT argue that by reducing trading volumes an FTT would enhance the ability of markets to allocate resources efficiently and allow important financial and human capital to be redeployed into more socially productive areas. Experts generally agree that collection of the tax through clearinghouses would be straightforward and cheap, and that tax avoidance can be minimized by applying the tax to a broad range of transactions across all jurisdictions. (4)
Staff of the European Commission (EC) and the International Monetary Fund (IMF) considered an FTT in 2010. Both of these reports rejected the tax in favor of other revenue raising schemes. The EC report indicated that "[e]ssentially, the debate on financial transaction taxes boils down to the question of the influence of transaction costs on trade volume and price volatility, and whether they can serve as a corrective device to reduce the number of allegedly harmful short-term traders." (5) Although the IMF report was more comprehensive in scope, it also focused primarily on short-term trading, liquidity, price discovery, volatility, and cost of capital effects.
This Article outlines and discusses the EC and IMF staff reports. We argue that the frameworks used to assess the efficiency, economic, and other effects of an FTT are unduly narrow. The primary argument in the reports is that increased trading leads to enhanced liquidity and lower transaction costs, which leads to lower costs of capital and improved economic outcomes (the trading cost of capital model). This argument is repeated like a mantra. However, the empirical research referenced in the reports is generally limited to microstructure studies, with the crucial links from the short-term price effects to long-term economic and community outcomes assumed rather than established. The critical bigger picture issues are glossed over in the belief that first, there is no evidence that the dramatic increase in market trading levels of recent years has been inefficient; and second, there is no decisive evidence that the way capital markets operate had anything to do with the crisis. We question both of these assumptions.
The main lesson to be learned from the GFC is that policy analysis founded on efficiency or economic outcomes must adopt a broad perspective and measure the impact of the policy upon the real economy over a long time frame. Policy assessment of efficiency and economic effects must extend beyond short-term financial variable effects to the likely longer-term economic impacts and public interest factors. Prior to the GFC, many claims were made about the effective risk management, efficiency, and innovativeness of the mortgage market and securistisation processes in the U.S. Few commentators stepped back from day-to-day events to think about the soundness and sustainability of the housing, mortgage, and securitisation trends.
Similarly, a farsighted, arms length, and pragmatic review is required of recent developments in capital market trading. Large institutions are driving ever increasing global securities trading levels. This is understandable as market participants have strong incentives in markets to try to outplay the next party. What is less clear, but crucial to understand, is why many policy makers and scholars are once again actively advocating and supporting market trading developments on efficiency, risk enhancement, and innovation grounds. Capital markets remain the best available mechanism to determine security prices and allocate financial resources efficiently. However, the net efficiency and economic gains from increasing trading activity are uncertain. Indeed, we argue that the trading cost of capital model is flawed--the asserted economic benefits are largely illusory, and the trading environment poses significant long-term risks to the real economy.
The market patterns of high frequency trading, computer generated activity and short-termism are now well entrenched, so behavior will be difficult to change. A serious response will require a range of carefully calibrated legal and tax policies. We support the introduction of a low-level FTT as part of this overall framework to promote greater alignment between capital market and economic activity. A transactions tax would discourage short-term speculative and technical trading and promote more stable and patient investment aligned with fundamental valuations. In contrast, a bank levy and FAT as proposed by the IMF will raise funds but will not reorient market trading behavior. For this reason, an FTT is to be preferred over an FAT.
Despite the negative EC and IMF reviews, discussion on a proposed FTT continues at a European and global level. Nicolas Sarkozy, the French President, and Angela Merkel, the German Chancellor, support the tax. (6) The EC notes that "[i]ntroduction of a tax on financial transactions ought to be as broadly based as possible or, failing that, the financial transaction tax should be introduced as a first step at [the] European Union (EU) level." (7) On this basis, President Barroso, Taxation Commissioner Semeta and Budget Commissioner Lewandowski publicly support a European based tax. In June 2011 the EC included an EU wide FTT as part of the funding in its long-term budget (2014-2020). (8) The EC will present the required regulations to the European Council and European Parliament by the end of 2011. (9)
At a global level, the communique from the G20 finance official meetings in October 2011 indicated that options for innovative financing and a range of different financial taxes were discussed. (10) The subsequent G20 summit communique in November 2011 acknowledged the initiatives in some countries "to tax the financial sector for various purposes, including a financial transaction tax." (11) This vague commentary, reflects the significant political divisions among the G20 countries towards an FTT.
Wolfgang Schaeuble, the German Finance Minister, argues that even though there is no consensus on a global based FTT, the tax is needed in Europe and will be implemented with great energy. (12) He suggests that if "we go ahead with an FTT a lot of other parts of the world economy will follow us." (13) Sarkozy told a news conference at the end of the G20 leaders' summit that "I remain convinced [the tax] is possible ... that it's indispensable financially given the crisis and that morally it is absolutely necessary." (14)
Given the high levels of public debt in Europe, the U.S., and elsewhere, the risks associated with sudden changes in trading activity, and the fragile state of international markets, we continue to call for a global FTT with support from all policymakers and regulators. (15) An international FTT would minimize market distortions and the transfer of trading activity to untaxed jurisdictions. (16) Should Europe establish a tax limited to the Eurozone, it should be carefully structured to minimize the relocation of financial activity and any negative effects on markets.
The tax should be designed to target trading issues of most concern, and its efficacy should be reviewed after five years. If a tax scheme is not introduced, other policy options to alter capital market structures and trading behavior should be considered. While the reforms included in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173) will assist, in the absence of an FTT, much more will be needed to ensure capital markets operate in the long-term interests of the global community.
This Article is in eight parts. Part II describes the market-trading environment. Part III outlines the arguments for an FTT. Part IV outlines the EC summary review of the FTT, while Part V discusses the more comprehensive IMF reviews of the FTT option. Part VI considers the administrative feasibility of an FTT. Part VII reviews recent developments. The final part provides our summary critique and conclusion.
The key market trends and general principles and concerns that underpin the need for an FTT are outlined initially. To properly assess the EC and IMF arguments and findings, an understanding of capital market developments is needed.
II. FINANCIAL MARKET TRADING--THE FACTS
Over the last twenty years there has been rapid growth in the levels of global market activity, well above those of the economy. (17) The ratio of the volume of financial transactions relative to nominal world gross domestic product (GDP) in 2007 was 75.3, compared to 15.3 in 1990. (18) The increase in volumes was driven by derivative trading, (19) as spot transactions of stocks, bonds and foreign exchange grew roughly in line with nominal world GDP. (20) 88% of the transactions in 2007 were derivative-based (21) and 64% were fixed income security derivatives. (22)
An increasing proportion of market trades are short-term and technically driven. In 2009, algorithmic (23) or computer-driven trading accounted for at least 60% of equity market trading volume in the U.S. and 30-40% of European and Japanese equity trading. (24) Similarly, 40% of the futures trading volumes in the U.S., 10-20% of the foreign exchange trading volume, and 20% of the options trading volume, were algorithmically driven. (25)
Many transactions involve "high frequency trading" (HFT) aimed at exploiting minor price fluctuations. (26) HFT typically involves the generation of massive numbers of orders for very short periods (often less than a second), many of which are subsequently cancelled to mask the true intent of the trader. (27) Estimates of the proportion of trading classed as HFT vary depending on the definition used but generally fall within the 50-75% range. (28)
HFT is founded on an ability to transact rapidly. To enable faster processing speeds, market participants are locating their systems beside or within the building of the relevant exchange. This co-location process reduces the latency time: the period it takes for the trading data to transact across the electronic trading systems. French hedge funds moved their trading computers to London because the time it took electronic messages to travel from Paris was placing them at a disadvantage. Similarly, Goldman Sachs moved its computers beside those of NASDAQ because each millisecond gained, by their calculations, added more than U.S.$100 million to company profits. (29) In January 2010, a project was discussed to build an optical cable through the Arctic Sea between the financial centres in London and Tokyo at a cost of U.S.$1.3 billion to cut latency times for data transmission from 140 to eighty-eight milliseconds." (30)
An increasing portion of market activity is being driven by hedge funds. Global assets under management in hedge funds have grown rapidly over the last decade to between $2-3 trillion in assets. (31) Kapoor indicates that
hedge funds dominate trading activity in equity markets, account for more than 50% of the volume in certain kinds of [over-the-counter (OTC)] derivatives, are by far the biggest players (by volume) in certain fixed income markets, are fast increasing their market share in foreign exchange markets and are prominent actors in commodity markets." (32)
Hedge funds already account for 90% the volume in convertible bonds, between 55-60% of the transactions in leveraged loans, almost 90% of the trading in distressed debt, and more than 60% of the volume in the credit default market. (33) Nevertheless, the share of market trading by hedge funds is likely to rise further as regulatory reforms such as the Volcker Rule in the U.S. (34) and more stringent global capital rules constrain banks from engaging in proprietary trading or owning hedge funds.
The benefits and risks posed by the hedge fund industry continue to be hotly debated. No evidence has been found suggesting that hedge fund activity directly contributed to the GFC. However, each financial crisis raises questions about the role played by hedge funds in financial markets. (35) Hedge funds were implicated in the 1992 currency crisis in Europe. There were also allegations of large hedge fund transactions in various Asian currency markets in the lead up to, and in the wake of, the Asian financial crisis in 1997. These concerns were compounded by the potential insolvency of the major U.S. hedge fund, Long-Term Capital Management, in 1998." (36)
The International Organization of Securities Commissions confirms that hedge funds play an important role in global capital markets. Trading by hedge funds can enhance price efficiency, market liquidity, product innovation, and investor asset diversification. (37) At the same time, however, the activities of hedge funds pose risks to market integrity, investor protection, and financial stability. (38) The amount of trading and the share of global securities transactions by hedge funds continue to grow. (39) Many hedge funds trade primarily in derivative instruments, which "compounds ... [the] problems of information and evaluation for bank management, [other investors] and supervisors alike." (40) These risks are magnified when financial markets are suffering from stress or instability, particularly when the hedge funds are large or highly leveraged. During periods of market volatility or reduced liquidity, the unwinding of concentrated or leveraged positions can cause major market dislocation and disorderly pricing. (41)
The sustainability of the ever-increasing levels of securities trading, in the form of derivative instruments with ultra-short holding periods by the largest financial institutions including hedge funds is questionable. However, it will not be easy to alter the entrenched patterns of trading, as the operations of capital markets are complex. To do so will require a range of substantive polices including changes to market infrastructure. The introduction of a low-level FTT as part of this process would promote greater alignment between capital market and economic activity.
III. PROPONENTS OF A FINANCIAL TRANSACTION TAX (FTT)
The FTT debate to date has centred on efficiency and economic goals and effects. Keynes was one of the earliest proponents of a securities transaction tax to curb speculative bubbles. He suggested in 1936 that the "introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprises in the U.S." (42) He argued that when:
[T]he capital development of a country becomes the byproduct of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield cannot be claimed as one of the outstanding triumphs of laissez faire capitalism--which is not surprising if I am right in thinking that the best brains of Wall Street have in fact been directed towards a different object. (43)
Similarly, Joseph Stiglitz indicated in 1989 that:
If, one thinks as I do, that the most important function (from the social view) of the stock market is raising new equity capital, one cannot but be struck by how, under current circumstances, it seems to do so little of this at great cost ... most of these resources are not spent in raising new funds but in rearranging ownership claims on society's resources ... Resources devoted to gambling--and to short-term speculation in the stock market--could be devoted to more productive uses. (44)
In the wake of the GFC, these long-standing arguments about speculative trading have intensified. The base of FTT supporters has expanded to include highly respected policy makers, academics, and practitioners. For example, the advisory committee of Redefine, a policy think tank actively campaigning for the tax, includes leading investment banking executives, policy makers, and scholars. (45) Warren Buffett and George Soros, who have made their fortunes in financial markets, also believe the tax would improve the operations of markets. (46) These parties are concerned about excessive trading levels, speculative trading, a pervasive culture of short-termism in markets, and the dislocation between capital markets and the real economy.
The debate has also broadened to encompass discussion on the role of the finance industry in society. An increasing number of commentators question the social usefulness of the growth of transactions that boost the relative and absolute size of the finance industry. Financial services have become such a significant part of the total economy in some countries that it is suggested that too many of the best-educated individuals in these countries are trading paper assets rather than creating real wealth. (47) The Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System highlights that the:
measure of success of financial policy should not be the rate of growth or the size of the financial sector as a share of GDP. Indeed, an excessively large financial sector relative to the GDP of a medium to large economy should be a cause of concern to those interested in long-term economic growth because financial crises are often associated with unsustainable growth of the financial sector. (48)
Similarly, Lord Turner, Chairman of the United Kingdom's Financial Services Agency, argues that the City of London has grown "beyond a reasonable size." He describes much of the current market trading as "socially useless activity," (49) and suggests that:
[P]arts of the financial services industries need to reflect deeply on their role in the economy, and to recommit to a focus on their essential and economic functions ... not all financial innovation is valuable, not all trading plays a useful role, and ... a bigger financial system is not necessarily a better one ... parts of the financial services industry have a unique ability to attract to themselves unnecessarily high returns and create instability which harms the rest of society .... (50)
Whilst the comments by Sdglitz and Lord Turner are profound, arguably they raise more questions than they answer. The underlying issues that remain largely unresolved include the following:
* What are the important connections and links from capital market activity to sustainable economic growth?
* What are the benefits and risks to society, from fair/unfair and efficient/inefficient capital markets?
* To what extent is financial services and trading activity in markets zero sum (that is, it merely alters the distribution of wealth among market participants without adding to economic and society outcomes)?
* How are the net economic benefits created from market activity, distributed? What proportion of the wealth created from market activity is simply redistributed to the finance industry in the form of higher salaries or profits?
* What types of financial innovations provide long-term value to the global community beyond the profits or wealth generated for the product creators?
* To what extent are short-term economic gains generated from financial sector activity during boom times mitigated or lost during subsequent crises or economic downturns?
Some of these "bigger picture issues" are being debated in various fora. For example, in April 2011, 1000 economists signed a letter to the G20 urging them to accept an FTT. (51) The letter states that the "financial crisis has shown us the dangers of unregulated finance, and the link between the financial sector and society has been broken.... It is time to fix this link and for the financial sector to give something back to society ... this tax is technically feasible. It is morally right." (52)
Much of the policy and scholarly debate relating to capital markets continues to be narrowly framed by short-term price efficiency goals and an assumption that capital markets work most efficiently when left alone. Such a framework is reflected in the EC and IMF reports that considered options to raise money from the finance sector in the wake of the GFC. The EC and IMF reports reject an FTT as an option on "efficiency" grounds and argue that most parties including consumers would be harmed by the tax. Both reports imply that the real economy and the public are benefiting from increased market trading levels due to enhanced liquidity and price discovery, which in turn reduces costs of capital. This core argument is presented as a fact that has been scientifically verified. However, the adopted theoretical and empirical frameworks to support the cost of capital arguments are not explained, the crucial connections to long-term economic outcomes are generally assumed, and any effects beyond efficiency factors are largely ignored.
The EC report (the Report) analysis is presented in a summary format. The IMF reported in two stages. A staff report in June 2010 provided summary arguments and conclusions. A later working paper by Matheson reviewed the issues more comprehensively. Most of our critique deals with the detailed analysis in the Matheson paper.
IV. EUROPEAN COMMISSION REPORT
In March 2010, the European Parliament adopted a resolution requesting the EC to assess an FTT in comparison to other revenue raising options. This process took place as part of the international debate, including by the G-20, on new sources of finance to: support fiscal consolidation; recoup the costs of bail-outs; fund future crisis intervention measures; and finance global development and climate change measures. (53)
The criteria used by the EC for assessing innovative sources were:
1. the potential for increasing the efficiency and stability of markets;
2. the effects on equity and income distribution;
3. legal and administrative aspects; and
4. its political acceptability. (54)
The Report ultimately rejects the argument by proponents of the FTT that "the tax would reduce noise and technical trade, thereby linking trade more closely to the underlying fundamental economic market conditions and make financial markets less volatile." (55) It questions the assumption that most short-term trading is highly speculative or based on technical trading, and suggests the time horizon of an investment is not a good predictor for the degree of speculation. It notes that short-term transactions are often related to trade or other commercial transactions and "it has proven to be extremely difficult to make a meaningful and operational distinction between speculative and non-speculative transactions." (56)
The Report argues that an FTT poses a risk of increasing the cost of capital for businesses and the cost of financial risk distribution. Further, the tax would increase the hedging cost for all companies and the use of derivatives as insurance devices could be seriously affected. (57) It even suggests the tax could increase financial costs for governments because they might have to pay higher interest rates. (58) The Report highlights that there is no empirical data to support the argument that the tax would be of a progressive nature, and expresses concern that it would burden pension funds that manage the savings of middle and low-income earners. (59) It stresses the need to properly define the scope of the tax, including the tax base and other administrative design features. (60)
Overall, the Report conclusions are strongly negative. The Report suggests the tax could have adverse effects on investment and economic activity and highlights the risk of potential loss of whole market segments if the tax is not comprehensive in geographical and product scope. (61) It raises potential legal issues around the free movement of capital and payments between Member States. (62) It also highlights the asymmetric revenue allocations, with most of the revenue collected in countries with significant financial centres. It points to the need for international solutions and questions whether an agreement to share the revenues internationally could be reached. (63)
The Report findings are myopic and overstated. The arguments concerning potential risk or adverse consequences arising from the trading environment are dismissed on the grounds that there is no evidence that the GFC was triggered by excess transactions and it is not possible to prove that ultra high frequency trading is speculative. (64) The factors the Report identifies as resulting in the crisis are limited to excess leverage and the taking of undue risk by financial institutions. (65) Put simply, the Report indicates there is no evidence of any issues arising from capital market activity and therefore no basis for any form of interference that may distort market functions. Yet the Report simultaneously makes unsubstantiated claims that the tax poses a risk of increasing "the cost of capital for business and the cost of financial risk allocation," (66) the use of derivatives for genuine hedging purposes would be seriously affected, governments may have to pay higher interest charges, the tax would have adverse effects on investment and economic activity, and pension funds would be burdened. (67)
As previously outlined, discussion on a proposed FTT continues despite the negative Report findings. In June 2011, the EC included an EU wide FTT as part of the funding in its long-term budget (2014-2020). (68) The EC will put forward a legislative proposal for the tax before the end of 2011.
The EC indicates that an FTT is likely to be introduced in the EU by January 1, 2018 at the latest. (69) The tax will apply to shares, bonds, and derivatives on shares and bonds. The proposed tax rates are 0.1 percent on shares and bonds and 0.01 percent on the derivatives of shares and bonds. The tax base applying to derivatives is the nominal value of the underlying assets. The proposed tax will be levied according to the fiscal residence of the seller of an asset (country of origin principle). The tax is expected to raise more than thirty billion euros by 2020 (70) and up to fifty billion euros should currency transactions be included. The revenues from the tax are to go to the general EU budget. (71) The proposal requires ratification by all member states to become effective. A unanimous decision would have to be taken on the final form of the 2014-2020 EU budget by the Council after consulting the European Parliament. As the UK remains firmly opposed to the tax, it is only likely to be implemented across the twenty-seven EC countries after a long tussle between national governments, the EC, and the European Parliament. (72)
The G-20 discussed an FIT when it considered options in 2009 to ensure the financial sector makes a fair and substantial contribution towards government revenues. The summit asked the IMF to prepare a report for their meeting in June 2010.
V. IMF REPORTS
As indicated earlier, the IMF reported in two stages. A staff report in June 2010 provided summary arguments and conclusions. A later working paper by Matheson reviewed the issues more comprehensively. The staff report notes that "[e]xpecting taxpayers to support the [financial] sector during bad times while allowing owners, managers and/or creditors of financial institutions to enjoy the full gains of good times misallocates resources and undermines long-term growth." (73) They acknowledge that many of the developed nations owed trillions of dollars in debt and funds had to be raised from the finance industry to build up reserves.
A. A Fair and Substantial Contribution by the Financial Sector: IMF Staff Final Report for the G-20
The IMF staff comprehensively reject the FTT option and conclude that it "does not appear well suited to the specific purposes set out in the mandate from G-20 leaders." (74) They indicate that an FTT is not the best instrument because:
* it is not the best way to finance a resolution mechanism;
* it is not focused on core sources of financial instability;
* its real burden may fall largely on final consumers rather than, as often seems to be supposed, earnings in the financial sector. (75)
The staff indicate that an FTT would not target the acknowledged attributes of systemic risk-institution size, interconnectedness, and substitutability. (76) They conclude that:
* the level at which the ratio of financial transactions to global GDP becomes socially unproductive financial activity is far from clear; * it is difficult to distinguish "undesirable" from "desirable" short, term trading;
* empirical evidence suggests an FTT would either not affect price volatility or increase it;
* some studies find these cost of capital effects are quite large, with potentially significant adverse impact on long-term economic growth;
* these increases would be greater for issuers of more frequently traded securities, such as larger corporations. (77)
They suggest it is not obvious that the incidence would fall mainly on either the better off or financial sector rents. (78) A large part of the tax burden may well be passed on to the users of financial services in the form of reduced return to savings, higher costs of borrowing and/or increases in final commodity, prices. They indicate that the tax incidence depends on the price elasticities of demand and supply and wider competitive conditions in the different markets in which the tax would operate. They suggest these relevant elasticities are not readily observable and mostly not available for G-20 countries. (79)
The staff argue that a weakness of the FTT is that it taxes transactions between businesses, and as a tax levied on transactions at one stage, it cascades into prices at all further stages of production. (80) They highlight avoidance difficulties and issues associated with swaps. (81) They conclude that "care should be taken in assessing the potential efficiency of an FTT in raising revenue." (82)
The staff ultimately recommend two levies; a Financial Stability Contribution to be levied on assets and accumulated to fund future bail-outs; and a Financial Activities Tax (FAT) to be levied on financial institution's profits and staff remuneration. They suggest a FAT be set at levels from 0.2 percent to 0.4 percent of a nation's GDP annually. (83) They indicate that a FAT would approximate a tax on rents in the financial sector if the base included only high levels of remuneration and the profit component excludes a normal return to capital. (84) They suggest a structure that taxes excess returns would mitigate excessive risk-taking and would tend to reduce the size of the financial sector with more certainty on its impact on the structure of financial markets than an FTT. (85)
As indicated previously, some countries, including France, Germany and the UK, have implemented levy or activity charges on their financial sectors. The revenue estimates for these charges are considerably less than for a global FTT. (86) More critically, these charges will not alter market-trading behavior.
B. IMF Working Paper: Taxing Financial Transactions: Issues and Evidence
Matheson of the Fiscal Affairs Department at the IMF provides more detailed discussion on the efficiency and economic effects of a tax on traded securities. (87) He reviews the literature on transaction costs and the potential effects on security valuations, costs of capital, market turnover, liquidity, price discovery, volatility, and waste, but concedes that many efficiency factors within capital markets and links to economic outcomes remain largely unexplored.
We argue that the base of information from which the EC and IMF conclusions are formulated is too narrow for real world policy decision-making. The conclusions are generally restricted to short-term price effects evidenced in microstructure studies by finance, economic, and accounting scholars. However, the limitations of these studies, the theoretical and practical assumptions underpinning them, and their links to broader macroeconomic studies are not explained. Moreover, the crucial links from the short-term price effects to long-term economic and community outcomes are assumed, without acknowledgment of the complexities around efficiency measures and effects in markets.
Nobody denies the importance of capital costs to economic outcomes. However, there are many uncertainties around cost of capital measures because they involve forward-looking analysis of "expected returns and pricing of risk." (88) Furthermore, there is "no well-accepted analytical model for relating trading liquidity with cost of equity." (89)
1. Asset Valuation and Cost of Capital
Matheson indicates that in accordance with economic theory, a steep decline in transaction costs over the past thirty five years has produced an increase in financial transactions relative to real activity. (90) He suggests that in line with theory, the lower transaction costs have encouraged primarily short-term trading. (91) He confirms that most of the growth in securities trading has been concentrated in derivative markets because these instruments typically have lower transaction costs relative to notional values than spot markets. (92) Matheson concedes that the explosion of derivatives trading, particularly for short-term security trading, raises concerns. He admits that the growth in derivatives trading "implies a corresponding growth in leverage, which increases liquidity and default risk, and may promote asset bubbles." (93) He also notes that the increasing dominance of computer generated trading poses technical and systemic risks, particularly when these trades are correlated or are subject to herding behavior, because this can potentially exacerbate price trends that are not fundamentally based. Matheson agrees that a tax that decreased short-term trading could reduce these risks. (94)
Nevertheless, Matheson indicates that theoretical models generally confirm that higher transaction costs, including those imposed by transaction taxes, are associated with lower asset prices. (95) He suggests that investors bid prices down to compensate for the higher cost to acquire or dispose of a security. In turn, the higher transaction costs raise the costs of capital for companies raising funds through taxed securities. (96) He notes the impact of an FTT on securities value and capital costs would be partially countered by the lengthening of the average holding period of securities, particularly for securities with narrow bid-ask spreads such as the stocks of the largest companies. (97) Accordingly, the "overall impact of a low rate (five basis points or less) FTT on the corporate cost of capital is ... likely to be quite modest." (98)
Matheson suggests the impact of an FTT on a company's cost of capital depends on the frequency of the trading in its shares, with an FTT having far more impact on the asset prices of securities with higher turnover such as large capitalization stocks. (99) However, he assumes rather than establishes the connecting links between short-term trading, asset valuation, and cost of capital.
Security valuation is a complex process that is affected by many variables. The securities of the largest companies are generally the most highly traded on a market. Any additional efficiencies generated from marginal liquidity changes to these already relatively liquid securities will reflect the law of diminishing returns. The argument that ever increasing levels of computer generated trading for holding periods of less than a second can infinitely improve a company's valuation and lower its cost of capital is incomplete and not really credible. These arguments overstate the importance of marginal liquidity and transaction costs within the security valuation process. They also downplay the market, valuation, and speculative risks associated with the increasing churn and decline in average holding period of securities. (100)
In any event, any efficiency benefits that arise from such trading must be weighed against the longer-term effects and risks, including the withdrawal of market participants due to a lack of fairness and confidence in the operations of the market; the potential for technology or momentum induced market issues; and the increasing market and financial system risks due to the increasing scale, concentration, interconnectedness, and short-term focus of the global trading environment. (101)
Matheson concurs with Tobin that the imposition of an FTT, which increases transaction costs in the form of a widening of the bid-ask spread, discourages short-term trading in particular. (102) By raising transaction costs, an FTT would lengthen the average holding period of securities, particularly those with narrow bid-ask spreads. (103) Matheson summarises the studies that examined the trading volume effects from higher transaction costs as showing a broad range of elasticities across markets. (104)
Matheson notes that studies on the volume effects vary across asset classes and jurisdictions, depending largely on the opportunities for avoidance. (105) He cites one study by Schmidt that found relatively low elasticity to transaction costs for trading in the four largest currencies (U.S. dollar, euro, sterling, and yen). (106) The Schmidt study finding is important, as it suggests that potential large dislocative effects from an FTT can be minimized by applying the tax broadly to secondary security trading across all jurisdictions.
Matheson then considers the liquidity and price discovery effects flowing from lower trading volumes. He highlights that a reduction in trading volume driven by an FTT also reduces liquidity, defined as the price impact from a given trade. (107) He suggests that lower liquidity can in turn slow the price discovery process that ensures that prices quickly and accurately reflect new information. (108) However, Matheson notes that other models find the effect of an FTT on liquidity depends on the market microstructure. (109)
The comment by Matheson that the effects of a tax on liquidity may vary is not surprising. Liquidity effects are complex and depend on:
1. the nature of the security;
2. the time period over which liquidity is measured;
3. market conditions;
4. momentum factors; and
5. investor confidence.
Secondary market trading is essential to maintaining liquidity in traded securities. However, the tax related liquidity arguments must reflect real world trading patterns. Most of the increased trading activity is in the derivatives of securities and not in the spot markets. (110) In addition, most of the increased trading is concentrated in the areas of the market that are traditionally the most liquid segments, namely, the fixed income and foreign exchange markets, and the equity securities of the largest companies. (111) No evidence is provided in the reports suggesting that the increased activity levels have materially improved the liquidity of the securities of smaller listed companies that tend to attract lower trading levels.
Second, short-term improvements in specified efficiency proxies may be negated over longer periods of time. For instance, while trading on private or inside information may in some circumstances enhance liquidity, empirical research suggests that any short-term liquidity gains arising from such trading may be outweighed over the long run by reductions in other efficiency measures such as bid-ask spreads, (112) price accuracy, and capital costs. (113)
Third, empirical studies indicate that liquidity responds asymmetrically to changes in asset market values. Liquidity decreases far more in conditions where market returns are decreasing than in positive markets. (114) The most significant liquidity issues arise following large market declines because the available collateral of market participants is reduced and many security holders are forced to sell, resulting in a lack of liquidity precisely when the market most needs it. (115)
Fourth, liquidity issues are subject to contagion. When an increased level of trading is driven by momentum factors, those trades are often one sided. For instance, on May 6, 2010 in the U.S., a large sell order of the Chicago Mercantile Exchange S&P 500 E-mini futures contracts and subsequent intense selling pressure driven by algorithms quickly drained the market of buy orders and led to a technology induced crisis (referred to as the "flash crash"). (116) Sustained liquidity requires a diversity of views and willingness to trade through all periods, particularly during negative market conditions.
Fifth, sustained liquidity also requires investor confidence in individual securities and in the markets generally. The most significant capital availability issues and negative increases in spreads tend to arise when investor confidence is lacking, weak, or volatile. These patterns were evident following the 1987 crash (117) and during the GFC, and investor confidence remains fragile in most markets, suggesting the alleged liquidity benefits resulting from high trading levels must be assessed over full economic cycles. Finally, it is worth highlighting again that there is "no well-accepted analytical model for relating trading liquidity with cost of equity." (118)…
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Publication information: Article title: A Financial Transactions Tax: Inefficient or Needed Systemic Reform?. Contributors: Buckle, Ross P. - Author, North, Gill - Author. Journal title: Georgetown Journal of International Law. Volume: 43. Issue: 3 Publication date: Spring 2012. Page number: 745+. © 2008 Georgetown University Law Center. COPYRIGHT 2012 Gale Group.