Holes found in Tobin Tax net

FINANCIAL TRANSACTION TAX PROPOSALS that have led to much argument and hand-wringing look set to become a reality. This month, the European Commission endorsed the tax, which would impose a charge of 0.1% on the exchange of shares of bonds between financial institutions where at least one of the parties was based in the European Union. This would raise €55bn (£48bn) a year, the impact assessment predicted.

Jose Manuel Barroso, the president of the EC, said it was “time for the financial sector to make a contribution back to society”. The UK is not happy. Around 70%-75% of all transactions involving an EU financial institution take place in London.

The business community has been united in its criticism of the charge. The Treasury has taken heed and the UK has promised to veto any moves to introduce it on a European level. But, even if the UK is not subject to the tax, the UK will still be affected.

But what are the problems with the tax? And, perhaps more pertinently, how likely is it to be adopted?

The economic dangers

The warnings have been stark. The inevitable first criticism is that it could drive financial institutions away from operating in London. With financial services making up 10% of the UK GDP (at least until recently), this is a worry. Icap, the London-based broking giant, has already threatened to quit the EU if it is introduced. Further movements could have long-term ramifications. Peter Cussons, PwC international tax partner, says that the US made a similar mistake in the past, introducing a withholding tax on bond interest in the 1970s. “The result of that was that all that activity moved to other centres, including London, and never went back,” he adds.

Another popular criticism is that it could destroy financial institutions’ business models. Tom Aston, financial services tax partner at KPMG, says that the implementation process for the tax will be “highly disruptive and expensive”. The tax “comes at a time when banks are already undertaking massive IT changes in response to regulatory changes”. It would also affect banks’ ability to build their capital base – something that is counter-intuitive to recent regulation, says David Newton, global financial services tax leader at PwC

There is also the warning that it could drive investors away. Angela Knight, chief executive of the British Bankers’ Association, said the £2.5bn levy on banks introduced in this year’s Budget has an effect on how much banks can lend. Changes in taxation and regulation mean that investors are more reluctant to invest in banking, she says – the varying international efforts to tax the banks in a myriad of ways mean that they never know what they are letting themselves into.

At last week’s conference on taxation and regulation at the Said Business School at Oxford University, the EC’s proposals were scrutinised by leading academics. One of the main flaws, they found, was that the transaction was levied based on the company’s residence. Therefore, a large financial institution would only have to undertake their transactions using a subsidiary outside the EU to avoid the tax, the academics found.

The economic arguments do not stop there. An analysis by the Financial Times suggested that pension funds and middle-sized companies will be hit, as they tend to use derivatives to hedge against swings in commodity prices and currencies and are unable to avoid the tax.

The political rationale

This is unashamedly a political measure, not an economic one. There has been talk from the EC about the usefulness of the revenue raised at a national level and an EU-wide level. But in the main, it has been couched in the language of fairness.

Introducing the tax, Jose Manuel Barroso, the president of the European Commission, said that in the past three years taxpayers have granted aid and guarantees of €4.6 trillion to the financial sector. “Some people will ask ‘Why?’. Why? It is a question of fairness. If our farmers, if our workers, if all the sectors of the economy from industry to agriculture to services, if they all pay a contribution to the society also the banking sector should make a contribution to the society,” Barroso said. With its VAT exemption, the financial sector is under-taxed compared with the rest of society, he added.

The point of the tax, he emphasises, is not just to tax the bankers. “This will help to reduce competitive distortions in the single market, discourage risky trading activities and complement regulatory measures aimed at avoiding future crises,” Barrosa said. “The financial transaction tax at EU level would strengthen the EU’s position to promote common rules for the introduction of such a tax at global level, notably through the G20.”

The tax would be levied on 85% of transactions that take place between financial institutions, the EC said, and citizens and businesses would not be taxed – “house mortgages, bank loans, insurance contracts and other normal financial activities carried out by individuals or small businesses fall outside the scope of the proposal”, a statement added.

A further rationale is found in the “implicit bailout guarantee” that banks enjoy. There was a belief that the government would bail out the largest because the effects of letting them fail would be disastrous. This became a real guarantee in 2008 – the National Audit Office estimated that the government guaranteed the banks to the tune of £850bn.

There is a suggestion that only a few banks benefitted from the government guarantees. But Clemens Fuest, professor at the Oxford University Centre for Business Taxation, refutes this theory: “The sector as a whole benefitted from the bailouts.” Because of the implicit bailout guarantee, “banks can borrow at lower rates than if there wasn’t a guarantee so in a way the taxpayer subsiding them.

The advantage that some parts of financial services receive from the VAT exemption is “questionable”, Fuest says, as business to business activity does not receive VAT relief. But the view prevailing in the literature suggests the exemption is a tax advantage, he adds.

Many of the economic arguments lose weight in that case. If banks do have implicit taxpayer subsidy, then asking financial institutions to change their business models is not necessarily asking too much; and the loss of investor confidence could be said to be redressing the advantage they have held on other sectors previously.

Well targeted?

However, even if you agree with the principle and the economics of “bashing the banks”, is the FTT the best way of doing so? Fuest says no.

There are many other ways of making banks pay a so-called fairer contribution. A bank levy, such as that in place in the UK, is a permanent tax on a bank’s debt. Chancellor George Osborne increased it to 0.075% in this year’s Budget. The banks are given an allowance of £20bn of debt, meaning that it captures systematically important institutions – those that, if they were to fail, would seriously affect the whole economy.

This would target the poor behaviour of banks that helped create the crisis by discouraging them from building up debt, Fuest says.

There is also the option of a financial activities tax (FAT), like that proposed by the IMF. This is a tax on the sum of the profits and remuneration paid by the bank. In the context of financial services, profits and remuneration is value added. This makes the FAT the closest in nature to VAT, which financial services are by-and-large exempt from. In his blog, Carlo Cottarelli, director of the IMF’s Fiscal Affairs Department, suggests that the tax could include only remuneration above some high level, and profits above a normal rate of return, or even only on profits above a level well above normal. “Taxing away some of these high returns in good times may help correct for any tendency to excessive risk-taking implied by financial institutions not attaching enough weight to outcomes in bad times,” he writes.

The bank levy and FAT combined would be far more targeted, Fuest says. The FTT does not address the problems we had that led to the crisis: “If we had the FTT, exactly the same would have happened.” During the crisis, there was too much debt and not enough capital.

One of the justifications of the FTT is that it will target high frequency trading (HFT). But this is not the biggest threat to the system, says Fuest: “The evidence that HFT is bad for the economy is inconclusive. More transparency is not a bad thing, but I do not think HFT should be abolished or forbidden.” If you did want to target HFT, regulation is the way to do this by, for example, increasing minimum holding times of shares, he says.

The effect on the UK

The tax looks far more likely now than it did six months ago. The proposals have the backing of French president Nicolas Sarkozy and German chancellor Angela Merkel. The UK has said that it will veto moves to bring it in on an EU-wide basis.

Peter Cussons says that the UK veto does not mean it is dead. Germany and France could “cajole” other countries into signing up to the tax, he says. A minimum of nine states are needed to sign it up on an enhanced co-operation basis. Although this would not apply to the UK, “a very real prospect is that there will be an FTT in a subset of the EU. That would be a bad thing.”

London transactions account for between 70% to 80% of all EU transactions and the all UK banks have subsidiaries in countries that are likely to sign up for the FTT. Although UK banks would be in the same position as their US counterparts, the proximity of Europe and the greater amount of business done with European states means that the UK banks would likely modify behaviour. If they choose to focus away from Europe, the UK will suffer.

One thing lacking from the EC proposals is details about where the revenue will go. We know that some will go to an EU fund and that it will be collected by the tax authority of the financial institution’s resident country. But we do not know what percentage will be taken by the EU or the home state.

FTT – OTT?

Many of the arguments in favour of the tax have been unfairly dismissed. There is a political angle to taxing the banks and it is too tempting to ignore this, but it is real. The banking sector has enjoyed significant taxpayer support in terms of both bailouts and the implicit bailout guarantee that allows them to borrow at preferential rates. Furthermore, as much of a cliché as it is, bankers’ bonuses are still in the headlines, with news of Goldman Sachs paying out an average of £191,000 to junior bankers in 1999 coming out in the details of a deal it struck with the taxman.

But even those that want to “bash the banks”, might fail to be satisfied by the FTT. Experts suggest better ways of making financial institutions pay a fair contribution than a tax which is easily avoidable and does not target poor behaviour.

The EU has more pressing issues at the moment. This does not mean it should ignore the genuine issue of making banks pay a fair share. But its it appears that many believe its energies would be better directed away from this inefficient method.