Just as with any other tax, the success of a financial transaction tax (FTT) rests entirely in its design. An FTT on security transactions is currently under debate in the context of enhanced cooperation of eleven EU member states. Implementation could go two ways: either the tax is ineffective or it successfully contributes to economic sustainability. A broad-based tax covering shares, bonds, derivatives and currencies can contribute to preventing financial speculation. Omission of securities on the other hand, is a clear invitation to circumvention. If, for example, derivatives or currencies, the biggest financial markets, remain untaxed even more trade will switch to them. This would clearly contradict the objective of the European Commission’s proposal to establish a broad-based tax to avoid evasive actions.
A broad-based FTT is crucial to real economic business: it can curb fictitious liquidity where excessive trading leads to unpredictable instability and drains liquidity when it is needed most. If asset prices become more stable, businesses will need to spend less on protection against volatility, thus freeing up capital for real economic investment. Even in Germany where, for example, private pension schemes are still comparatively small, these funds exert enormous market power: with an investment volume of about 480 billion euros German pension funds exceed the country’s entire federal budget which is under 300 billion euros. An FTT can prevent pension funds from short-term trading, making them more secure, and lowering the costs customers are charged for the fund management in which, furthermore, simplicity has proven to outperform complexity.
The potential steering effect of a financial transaction tax is unique
The main difference between the FTT and a value added tax is that an FTT applies to every transaction. This is also the difference between the FTT and a financial activities tax that relates to the end profit. Hence with the FTT, high trading frequency is tied to higher taxation. Thus the tax can slow down excessive trading activities.
The issuance principle as proposed by the European Commission will also increase the tax effectiveness: whenever a security of a participating country is involved, its trade is taxed wherever it takes place – for example, a French bond traded in London or Singapore. This means that even a regional FTT applies to trades across the globe. If the issuance principle is combined with the residence principle, every transaction involving a customer or a financial institution from a participating country will be taxed as well.
The tax is a great opportunity to curb fictitious liquidity in the repo-market, where financial institutions post securities such as bonds repeatedly as collateral. This practice drives up leverage in the financial sector instead of limiting it. The multiple use of securities as collateral leads to phantom collateral that easily causes and intensifies market distortions. It can make bond prices fall far and fast below their fundamental and long-term value.
To enhance its steering effect, the tax rate should be scaled up in boom times. Economist Paul Bernd Spahn already suggested a scalable tax rate in 2002 in a report commissioned by the German Federal Ministry for Economic Cooperation and Development. Currently, the European proposal foresees only a fixed small rate of 0.1 percent for shares and bonds and 0.01 percent for derivatives. The importance of the steering effect is still neglected and crowded out by the general objective to raise revenues. Many reforms can be envisaged to raise revenues from the wealthy and the undertaxed financial sector, but the potential steering effect of the FTT remains absolutely unique. By preventing economic harm, the costs that can be saved with an FTT are predicted to significantly exceed its revenues.
Europe severely lacks good governance
Financial regulation must serve the overall economy and society. Yet, despite the financial crisis, Europe still prioritises financial sector special interests. The game plays out as follows: governments announce a regulation such as a financial transaction tax. Financial sector representatives complain, often spreading misleading messages. The proposed tax then easily becomes ineffective. Whilst governments claim to act on behalf of society they are in fact kowtowing to financial sector special interests. This is the opposite of good governance. It is regulatory capture.
The financial sector's calls for exceptions are loudest where the tax is most effective. The tax has the potential to “throw some sand in the wheels“, according to the FTT’s first proponent, economic Nobel laureate James Tobin. This explains the protest. High-volatility activities are high-return activities for a select few. Currency traders are among the best paid. However, governments are elected for the purpose of democratic decision making and independence from financial corporate government. They are, in theory at least, there to represent the best interests of wider society – something a broad FTT would serve remarkably well.