EU financial transaction tax will harm long-term investors

The introduction of a financial transaction tax – as voted for by European politicians last week – will increase costs for long-term investors and decrease market efficiency, market participants have warned.
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The introduction of a financial transaction tax (FTT) – as voted for by European politicians last week – will increase costs for long-term investors and decrease market efficiency, market participants have warned.

In a non-legislative resolution on innovative financing that was voted through on 8 March, the European Parliament (EP) urged the adoption of a broad-based FTT, even if Europe was alone in doing so.

The EP considered that such a tax could “help to tackle the highly damaging trading patterns in financial markets, such as some short-term and automated high-frequency trading transactions, and curb speculation”. It added that a low-rate FTT would improve market efficiency, increase transparency, reduce excessive price volatility and incentivise long-term investments that benefit the real economy. According to the resolution, a low-rate FTT could raise up to €200 billion per year in Europe and would be easily and cheaply implemented at the clearing and settlement level. The EP voted 529–127 for the adoption of the paper, with 19 abstentions.

Despite the strong majority of MEPs that voted for the FTT, the EP does not have the power to propose new laws and cannot compel the European Commission (EC) to do so either.

However, the paper will put pressure on the EC to consider legislative proposals seriously, according to Judy Harrison, senior associate, tax department at law practice Norton Rose.

“The EC has been looking at this issue for some time and indicated at the end of last year that it would support a global FTT,” she said. “But the EP paper will put pressure on the EC to seriously consider whether to implement an EU-wide FTT. However, the introduction of an EU-wide tax would require agreements from each member state – which could be difficult to achieve.”

The EP's resolution reflects discontent among MEPs at the limited progress by the EC in examining the issue further since it was first suggested over a year ago, said Vimal Tilakapala, tax partner and co-head of Allen and Overy's ECO tax practice.

“This paper seems like a protest from the EP, given that the motion refers to momentum being lost,” he said. “It's significant as it shows a desire among the EP's members for this to happen, but the EC seems to be considering it in a more sophisticated way. The EP has said this approach will move speculative transactions offshore, but this seems very naïve.”

The EC, it seems, will not be rushed. In a statement released just after the EP vote, Algirdas Å emeta, the European Commissioner for taxation and customs union, audit and anti-fraud, said, “I firmly believe that it is premature to commit to such an option. In fact, taking into account the potential impact that this could have on European competitiveness, it would be irresponsible to proceed with such a tax without first analysing and fully understanding all the implications.”

Å emeta said the EC will present an in-depth analysis of the possible options for taxing the financial sector “by the summer”.

Market concerns

Market participants are worried that the impact of a FTT could spread beyond speculative activity. In particular, it could act as a disincentive for market makers to provide liquidity as they adjust their business models to cope with extra costs.

“Market makers that work on low-cost but highly-scalable infrastructures would probably be able to absorb part of a financial transaction tax, while putting some of it back into the market by widening spreads they are willing to quote at,” said Kee-Meng Tan, managing director and head of agency broker Knight Capital's trading group in Europe. “Furthermore, smaller market makers could drop out of the market completely, reducing competition, further widening spreads, reducing liquidity and increasing volatility. The investing public would therefore suffer as these consequences would result in inferior execution quality and reduced liquidity for long-term investors.”

Financial markets trade bodies said the tax would hurt investors and weaken growth prospects in Europe.

“The imposition of an FTT would materially damage retail and institutional investors,” said Stephen Lynam, head of tax at the Investment Management Association, a UK-based trade body. “There has been little rigorous analysis or modelling to examine whether the benefits of reduced short-term trading would outweigh the direct costs of the tax to long-only firms.”

The Association for Financial Markets in Europe (AFME), which represents sell-side views, added that the new tax is likely to shift a significant proportion of financial market liquidity to non-European markets, despite the EP's suggestion that the flow of “merely speculative transactions” to other jurisdictions would have little detrimental impact.

“Any proposed transaction tax would risk causing serious damage to the markets, as well as increase costs for a large section of European industry to the detriment of economic growth,” said an AFME spokesperson. “There are also challenges in the workability of such a tax.

In the case of the foreign exchange market, for example, trading is likely to move offshore unless any such tax is introduced globally.”

The London Stock Exchange (LSE) also stressed the potential damage a FTT would cause to economic growth.

“Financial transaction taxes have been shown to suppress economic investment to the extent that GDP, and consequently overall tax revenues, are significantly harmed,” said an LSE spokesperson. “UK stamp duty for example is a regressive tax that has been shown to cost the Treasury the same in lost revenues that they get from the tax itself, while penalising long-term savers and making growth funding more expensive for employers. These considerations are critical in evaluating the validity of financial transaction taxes and should be taken into account if this proposal comes before the European Commission and individual member states.”

In October 2010, a study from the Institute of Development Studies (IDS) at the University of Sussex, England, noted that a tax rate of 0.116% on equity trades – equal to 10% of existing transaction costs – would yield US$100 billion (€71.6 billion) globally and US$4 billion (€2.86 billion) from the UK each year. The calculation incorporates an expected reduction of trading volumes that would arise if a tax were implemented.

The IDS research also noted that an FTT might not reduce market volatility. While theoretical assumptions claim that a tax would reduce the amount of short-term speculation, and therefore decrease volatility, the study argued that the reduction in trading and market activity that results from an FTT could “squeeze liquidity” and subsequently increase volatility.

The idea of a FTT was first introduced by economist James Tobin, a former Nobel prize laureate who suggested that a tax be applied to foreign exchange markets to penalise short-term speculative behaviour. The idea was thrust back into the spotlight following the financial crisis by the UK-based Robin Hood Tax campaign, which now has over 82,000 members.