(Corrects to reflect possible tax treatment of contracts for difference.)
It’s easy to understand why the European Union wants to slap a tax on financial companies when they buy or sell stocks, bonds, and derivatives. Europe is still grappling with fallout from a global recession triggered by the financial industry’s recklessness. And oh yes, there’s that $40 billion in revenue that the tax is estimated to raise.
Sweet revenge? Bitter disappointment is more likely. Earlier attempts to tax financial transactions have spectacularly failed to meet revenue expectations, as trading activity simply moved abroad.
Consider what happened in Sweden after transaction taxes were introduced there in the mid-1980s. “Taxable trading volumes fell sharply, and actual tax revenues were less than 5 percent of the expected amount,” as 80 percent of bond trading moved offshore and the options market dried up, says economist Andreas Johnson of Swedish bank Skandinaviska Enskilda Banken (SEBA). “By the end of 1991, these taxes had been abolished completely.”
The U.S. spurred a similar exodus in the 1960s when it began taxing purchases of foreign securities by American investors. That spurred creation of a Eurobond market—first in London and later in Asia and other locales—that now handles some $3.7 trillion annually in corporate fixed-income transactions. A Eurobond is a bond denominated in a currency other than that of the country where it is issued.
Taxes on financial transactions “stem from the desire of politicians to punish the markets,” says Bill Blain, a fixed-income strategist at Mint Partners in London. “But markets can always vote with their feet.”
In unveiling the proposed tax on Feb. 14, EU officials said they had created “safety nets” to prevent such flight from 11 euro zone countries that have signed onto the plan. The countries could impose the tax on securities trades executed anywhere in the world, so long as one party to the transaction had a business presence within the euro zone. The idea is that, say, a London-based bank with operations on the Continent would be unable to escape the tax by executing a transaction in Britain.
The tax would apply to almost all sectors of the financial industry, including pension funds. Day-to-day transactions by individuals and nonfinancial companies would be excluded, as would primary stock and bond offerings and trades with central banks.
Not surprisingly, the proposed tax has sparked outrage in the City of London. The British Bankers’ Association described the measure as an effort to “damage the City by the back door.” The London-based Investment Management Association, which represents fund managers, said the cost to investors would be “substantial,” because both the buyer and the seller for each transaction would have to pay 0.1 percent for stock and bond trades and 0.1 percent for derivatives transactions.
Still, the betting is that financial and legal wizards will quickly find loopholes. One possibility—which France discovered to its chagrin last year after imposing a 0.2 percent tax on share purchases—is the creation of synthetic trading instruments. In France’s case, brokers started selling so-called contracts for difference, which allowed clients to bet on a stock’s gain or loss without actually owning it.
After initially predicting the tax would raise more than $2 billion this year, President François Hollande conceded in November that it would have only a “modest” effect.
The EU proposal can’t block the use of contracts for difference, since they are derivatives, but it can impose a transaction tax on them. “The incentives are so great and the options so limitless to outwit the tax authorities, that I think the transaction tax is going to be a big mistake,” says Alec Chrystal, an emeritus professor of finance at Cass Business School in London. “Taxes should really focus on the ultimate income recipients and not on the markets or intermediate entities.”
Instead of punishing the finance industry, EU governments could end up harming their own economies, says Blain of Mint Partners. “The immediate result will be to diminish liquidity,” he says. “Anyone who is holding these instruments either will let them lie fallow, or else people will rush to sell them, and the prices will tumble, which will push up European borrowing costs. They’re shooting themselves in the foot.”
With reporting by Kevin Crowley, Ambereen Choudhury, and Rebecca Christie of Bloomberg News
