Financial Transaction Taxes: Tools for Progressive Taxation and Improving Market Behaviour. The discussion on financial transaction taxes is reaching a climax. There have been several suggestions for the form such a tax should take and many estimates for how much revenue levying such taxes would generate often running into hundreds of billions of dollars.
In a new Re-Define policy brief we have addressed the all important question of the incidence of financial transaction taxes, seeking to answer the question ‘who pays in the end’, should FTTs be widely introduced. We also demonstrate how a differentiated transaction tax regime can address market behaviour issues such as churning and excessive short termism as well as help reduce systemic risk.
The initial incidence and capacity to pay
Across a number of market segments trading volumes are increasingly dominated not by traditional investors such as pension funds or insurance firms but by high frequency traders, hedge funds and investment banks. We further show that the initial incidence of the tax falls on the dominant actors who also have the capacity to absorb a large proportion of the tax. This ensures that the tax burden is highly progressive falling mainly on those most able to pay – hedge funds and investment banks and their highly paid employees. Moreover, governments would be able to take steps to minimise even the small effect on the pension funds or savings of the broader public.
The final incidence of the tax is highly progressive and can be made more so
Based on our analysis the final incidence of financial transaction taxes will fall on a number of actors, in particular
- High net worth individuals invested in hedge funds
- Employees of hedge funds
- Shareholders of investment banks
- Employees of investment banks
A much smaller burden of the taxes would fall on
- Institutional investors such as pension funds
- Corporate and retail users of financial services
Overall, the financial transaction tax is likely to generate significant revenues net of any cannibalization of other forms of taxes. This effect will be enhanced especially because the primary burden of tax will fall on hedge fund investors, hedge fund managers and investment bank employees.
Investment banks are very heavy users of tax planning schemes and tax avoidance strategies and often pay much lower effective rates of taxes compared for example to companies in the real economy. Hedge funds are mostly located in offshore tax havens with managers as well as the high net worth individuals who invest in them being heavy users of tax avoidance schemes. So taxing them through financial transaction taxes would both be highly efficient in terms of generating additional tax revenue and progressive in terms of its incidence, since these are amongst the highest earners in the world.
Such taxes could raise significant additional revenues of the order of $200bn - $400bn with minimal impact on the real economy or retail consumers. The tax will have a highly progressive final incidence that falls mainly on the top income earners and wealth holders in society.
Policy makers can make sure that the final incidence of the tax is most progressive and is borne to the greatest extent by actors within the industry by
- Levying a higher tax on market segments where hedge funds and investment banks are the main actors
- Increasing competition in the financial services industry. For example, high barriers to entry and low competition are one reason that investment banks are able to earn excessively high profits
- Introducing restrictions on employee compensation in the financial services industry which would increase the amount of revenue available to absorb the additional costs of the tax
- Tougher controls on excessive charges for end users
- Using an exemption and refund regime that reduces the burden of the tax for certain segments such as pensioners
Improving market behaviour and information efficiency
Financial transaction taxes, applied well, are an excellent tool to address the increasingly serious problem of short-termism in financial markets. They have a significant potential to improve the informational efficiency of financial markets and will encourage a long term investment horizon more compatible with sustainable and productive investments.
Moreover such taxes can also help reduce churning, excessive short-termism and volatility may generate substantial efficiency gains for the economy.
Policy makers should introduce a well-thought out differentiated schedule of taxes across markets could improve market function and reduce systemic risk by
- Penalizing excessive short-termism across all markets
- Penalizing complexity by imposing higher rates on more complex transactions
- Penalizing opacity and excessive counterparty risk by imposing higher tax rates on over the counter transactions and
- Imposing higher rates of taxes on socially harmful or less useful transactions
As a next step, policy makers should introduce differential rates of taxes across different product markets using the suggestions we have put forward in the last section. We will continue to address key issues for policy makers through this series of Re-Define policy briefs
“A Financial Market Solution to the Problems of MDG Funding Gaps and Growing Inequality”, Sony Kapoor speech at the Innovative Finance Conference hosted by the Korean Government, 2007: http://www.re-define.org/publications
“Controlling Bonuses, Taxing Transactions and Imposing Levies Complements not Substitutes”, Presentation and Paper by Sony Kapoor, Ministry of Finance Netherlands, 2010
“Steuerpolitik nach der Krise - Innovative Ansätze aus dem europäischen Ausland", Presentation by Sony Kapoor, Ministry of Finance Germany, 2009
“Transaction Taxes: Raising Revenues and Stabilizing Markets”, Report for a Stamp out Poverty project financed by the Co-operative Bank, Sony Kapoor, 2004