A FIT Proposal - Financial Instrument Taxes
The world has woken up to an urgent fiscal challenge. Budget cuts will soon start to bite at home in Europe, while funding for international development and tackling climate change has already been cut. Meanwhile, the financial system that got us into this fiscal mess remains largely unreformed, with proposed changes largely neglecting the issue of systemic risks posed by financial markets in favour of ‘quick fix’ changes to the banking system. Even less has been done to align finance with the real economy.
Implementing a series of Financial Instrument Taxes (FITs) offers a highly flexible toolkit to help achieve progress on all three fronts. These are similar to, but broader than, the widely-discussed financial transaction taxes (FTTs), and can be tailored to the idiosyncrasies of particular markets. For example, more liquid markets in stocks, futures and certain derivatives will be taxed on a per transaction basis, whereas illiquid securitized products, mortgages and OTC derivatives would be taxed on issuance.
In this regime, relatively higher FIT rates would apply to products that pose higher systemic risk. So, derivative transactions that are more complex, less transparent, or traded over the counter would be penalized with higher rates. Moreover, a highly attractive aspect of FITs is that tax rates can be varied counter cyclically to curtail the build up of systemic risk: overheating markets can be cooled down through an increase in tax rates, while in a market downturn, FIT rates can be slashed.
Beyond their allure as macro-prudential tools, FITs also have the capacity to generate highly valuable information. For example, the CPMF, Brazil’s financial transaction tax, not only mobilized substantial tax revenue, but also generated data that helped reduce tax evasion. Similarly, India introduced a cash transaction tax with the primary objective of generating useful tax enforcement information, while a senior government adviser in China recently floated the idea of levying such a tax on foreign exchange primarily to identify speculators. At a time when we are still paying the costs of inadequate oversight of the financial system, the potential role of FITs to generate information on trading activity is critical, and should indeed be one of its explicit goals. Such a FIT regime will not only help reduce revenue-depriving tax flight, but would also ensure that an audit trail exists for financial instruments so regulators can better locate financial sector risks.
Furthermore, the implementation of FITs would tackle the growing problems associated with emerging trading patterns, such as automated high frequency trading strategies and algorithms designed primarily to chase the trend. While niche machine trading may have enhanced diversity and liquidity in the market, its dominance now impedes market efficiency. Collectively, machine based trades can exacerbate trends and increase volatility; more seriously, they pose a severe and growing threat of systemic breakdown as seen most recently in August 2007 and May 2010. Levying a small transaction tax would reduce this systemic risk through rebalancing the market away from automatons by reducing their profits. It would also reduce some of the excessive short-termism that increasingly afflicts financial markets.
Critics allege that financial market taxes are very difficult to implement, would mainly be paid by small savers, and would seriously damage market liquidity by reducing the number of transactions. These criticisms are easily addressed.
First, experience with such taxes in the UK, India and Latin America, makes it clear that the electronic nature of markets makes them easy and cheap to implement, and difficult and expensive to avoid. Furthermore, regulatory reforms, such as the increased use of central counterparties and trade repositories for derivatives, would make this evasion even more difficult. FITs can be unilaterally implemented on markets such as stocks, bonds and real estate. Derivative and currency markets can be captured at the level of the European Union. So, while a G-20 agreement is desirable, it is not imperative. Merkel’s commitment to EU level financial market taxes is not just empty rhetoric, but a realistic goal.
Second, a small saver exemption with a provision for tax refunds should be built into the system to ensure that the tax incidence is progressive. It helps that the first incidence of a FIT regime will fall mainly on hedge funds, investment banks and large fund managers, not on commercial banks.
Third, liquidity, which measures the price impact and ease of transacting, is only indirectly related to the frequency of transactions. A highly liquid market can have few transactions, while a market with many transactions can be highly illiquid. True liquidity comes from a diversity of opinion, and FITs can increase liquidity by rebalancing the market away from uniform algorithms towards a more diverse set of market participants. FITs could also smooth market functioning by filtering out spurious boom-time liquidity, whist not affecting the true liquidity that is robust to downturns.
Yet, no matter how convincing the arguments, do not expect the financial industry to support FITs. If in genuine doubt, policy makers should simply start with a tiny rate, say 0.001% or less, on select markets and increase the rate and scope incrementally after regular impact analyses.
FITs can raise some serious money to hurl at those yawning fiscal deficits, as well as worthy causes such as international development and tackling climate change – as much as $250 -$350 billion annually by our estimates. What’s more, a well-designed FIT regime will have a highly progressive incidence, earn political capital and reap significant regulatory rewards. It is also a natural market-based complement to a bank-based levy.
Having a flexible toolkit that makes substantial progress on three important policy goals is rare. It would be foolish for politicians and regulators to miss the opportunity to implement this very FIT proposal.
Sony Kapoor is an ex-investment banker and Managing Director of the think tank Re-Define (www.re-define.org). This piece is based on his testimony at the European Parliament and the German Bundestag and an Op-Ed in Financial Times Deutschland.