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Simon Zadek


Financial Transactions Tax, RIP

Posted: 10/22/11 10:00 AM ET

The Financial Transactions Tax is surely dead. May it rest more peacefully in future. Surging objections to the European proposal, indeed ridicule, have come from almost every quarter, from leading lights representing the "responsible investment movement" to the IMF's former chief economist, Kenneth Rogoff. Beleaguered European Commission President José Manuel Barroso will find it hard to continue circulating in polite society if he sees through his high-profile support of the tax to the bitter end.

Yet the benefits of a value-added tax, essentially a transactions tax, on almost every other industry, and certainly on Joe Citizen at every opportunity, is widely accepted and forms an increasingly important portion of global tax revenues. So emotion and interests aside, what's the problem? I decided to take a look-see.

Needless to say, there is not one but a multitude of interlocking objections to the tax. I have picked out three to highlight. First in the dock is the "efficient market hypothesis," an awkward term for a view that has, unbeknownst to most of us, come to dominate our lives. In a nutshell, this inelegant phrase suggests that markets, left preferably to themselves, will deliver the best result for society by allocating information, capital and outcomes "as good as it gets." Messing around with markets, such as by introducing taxes, distorts them, makes them less efficient, and delivers poorer results. A financial transactions tax, following this logic, will constrain transactions that would otherwise optimize financial markets, increase volatility, increase perceived risks, raise the cost of capital, reduce investment flows, damage the economy, reduce risk adjusted returns to pensioners, and in general do harm to us all.

There is nothing inherently problematic with this argument. Indeed, it may well be right. The only minor problem is that we have no idea in practice whether it is right. In a second-best world with many blemishes in markets, and notably with demonstrable short-term biases in financial markets, it is utterly impossible to predict the impact of a financial transactions tax on market efficiency, let alone the cascade of effects described above. Some research suggests that such a tax would increase volatility, while other research suggests that by advantaging long-term investors, volatility would fall. All we can be really sure of is that we don't know.

Rogoff, secondly, presents a different, although curiously related argument, which, when simplified down, amounts to the view that taxing capital is bad for the economy:

"Higher transactions taxes increase the cost of capital, ultimately lowering investment. With a lower capital stock, output would trend downward, reducing government revenues and substantially offsetting the direct gain from the tax. In the long run, wages would fall, and ordinary workers would end up bearing a significant share of the cost."

Fair enough, penalizing the owners of capital by taxing some element of their profits must pose some kind of disincentive to them. But Rogoff's argument appears quite unlimited in its presentation, applying it would seem wherever and whenever a tax on capital was being proposed. His remarks, that is, have apparently little on this score to do with the financial transactions tax in particular, but presumably imply that he favours taxing labour and consumption over capital, or perhaps if possible not taxing at all.

By far the strongest objection to a financial transactions tax concerns the potential for traders to avoid it by moving their operations for taxable purposes to other jurisdictions. The European Commission's own study, as the Financial Times points out, "expects [the effect of a financial transactions tax to be that] 10 per cent of securities market transactions either leave the EU or disappear, while the volume of EU derivatives trades will plummet by 70 to 90 per cent."

Frankly, this might be a real downside, although the EC defends its support of the tax by arguing, unusually provocatively, that "such disappearance could be seen as positive if the activities targeted are considered as harmful." And it is true, certainly, that those raising the red or indeed the green flag in relation to these taxes have some work to do in setting out the value of, say, high-frequency trading to the jurisdictions in which they take place (beyond high property prices). The jury is out with strong arguments on both sides. No less a financial guru as former UK City Minister, Lord Myners, has made the point that such black box trading is bad for financial markets and the economy as a whole. Once again, I struggle to find convincing evidence one way or another based on robust analysis rather than emotive views.

But Rogoff's argument is more fundamentally problematic. Opposing a tax because of the potential for private actors to avoid it appears eminently pragmatic on the surface, but is surely a little scary on deeper reflection. Where might such perverse arguments take us on other matters of criminality and morality? Surely one would expect the former chief economist of the IMF to help us all out by explaining how best to overcome such regulatory arbitrage, rather than accepting as an inevitable, acceptable, or perhaps even desirable fact of life that regulators and tax authorities can be outrun and indeed outgunned by their targets. At least the UK Government, albeit some might suspect disingenuously, has professed a willingness to consider such a tax if it is embraced across the G20.

It may well be that a financial transactions tax is not viable given the circumstances, or that Rogoff and others are right that it is just a lousy idea on any day of the week. But this surely misses the point. Financial folks make super-profits using our capital, and keep rather a lot for themselves in the process ― fair's fair, as Barosso argues, we have saved your skins, now you need to be part of a solution to the wider repercussions of (in part) your actions. And secondly and more substantively, we need to find ways to harness the financial markets to our real needs, for stable financial returns and investment flows into a sustainable economy for us all.

Rogoff and others would be more convincing if they spent more time in offering up urgently needed solutions to these two inter-related problems, rather than appearing to offer professionally crafted justifications for the current, quite unsustainable, status quo.