Financial Transaction Tax: Impact on the EU’s Financial Sector

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On 28th of September last year, in the annual State of the Union address, José Manuel Barroso, President of the European Commission, announced the proposal for a European financial transaction tax. The concept of this tax is supported by France and Germany yet is strongly opposed by UK and some other EU Member States.

Overview of the Proposed Financial Transaction Tax

The financial transaction tax, often referred to as “Tobin tax” after its original advocator, James Tobin, in the 1970s, would impose a levy on individual transactions undertaken by financial institutions.

This tax would be payable on all transactions of equities and bonds at 0,1 percent of value and on all derivatives transactions (both exchange-traded and OTC) at 0,01 percent of value calculated on the basis of the derivatives underlying value. It would exclude government bond auctions, while including secondary-market trading and repurchase-agreement markets.

The EU’s executive of the Commission has proposed implementing a tax starting in 2014. It will apply to the specified transactions conducted between banks, insurance companies, investment funds, stockbrokers and hedge funds and other financial firms.

The European Commission (EC)also states that activities related to citizens or businesses would remain free from the taxation, such as concluding insurance contracts, mortgage lending, consumer credit and payment services.

The financial transaction tax would be charged by reference to the time that the transaction is entered into (even if the transaction is subsequently cancelled). The tax will generally be levied on the price or value of consideration provided or, in the case of a derivatives contract, on its notional amount.

The European Commission estimates that the proposed tax will raise approximately 25-43 billion euro in revenue annually.

The tax has two main purposes. Firstly, it is meant to slow down overheated financial markets. The Commission aims through a Tobin tax to discourage excessive speculative trading activities and to reduce undesirable market behaviour. Some experts say that the tax is likely to lengthen holding periods significantly. Traders that operate on a high turnover strategy and very thin profit margins could find that the tax badly undermines the viability of their operations.

The second objective is to force the EU’s financial sector to share in the costs created by the recent crisis and the costs borne by EU taxpayers in the form of state bailouts. The Commission views the proposed financial transaction tax as a revenue-raising tool in its endeavour to recoup part of these costs.

Some experts say that these two objectives are, at least in part, mutually exclusive. Should the first objective be reached and the numbers of transactions fall, financial transaction tax revenues would consequently fall too.

Unequal Distribution of Tax Burden

British Prime Minister David Cameron strongly opposes the introduction of a Tobin tax, as it is likely to have disproportionate significance for the UK. The size the UK’s financial sector is vast relative to its neighbouring states. By contrast, in countries like Germany or France, where the “real economy” in general and manufacturing in particular serve as main drivers of economic growth, the impact of the tax will be less severe.

According to Ernst & Young ITEM Club report, if the transaction tax is introduced across the EU, the UK financial sector would generate around 75% of the total revenues. Source.

As many euro-denominated trades take place in London, this could effectively impose a transaction tax on the UK through the back door, the ITEM Club said in the report. If a reverse charge mechanism was applied, and if the UK were to opt out of the financial transaction tax, the UK financial sector would still contribute around 60% of total revenues. These revenues would flow directly to governments in the Eurozone rather than to the UK.

According to ITEM Club, an EU-wide tax applied with British agreement would raise 53 billion euro a year, of which the U.K. would contribute 41 billion euro. If it was applied across the euro area only and Britain remained opposed, the tax would raise 35 billion euro, of which the U.K. would contribute 22 billion euro.

ITEM Club also claimed that the latter option would lead to about 2,100 job losses in the U.K. financial-services industry. Taking account of “spillover effects” on other industries, total job losses could reach as many as 4,500 nationwide. Source.

Tax Effect on the Foreign Exchange Market

A financial transaction tax would have a particularly negative effect on the foreign exchange market. According to Oliver Wyman report commissioned by GFMA’s Global FX Division, transaction costs of foreign exchange operations would increase by 9 to 18 times after introduction of the tax. In turn, it will hit the economy as these costs would largely be passed onto all end users, such as Europe’s financial institutions, pension funds, asset managers, insurers and corporate clients. Source.

The report, ‘Proposed EU Commission Financial Transaction Tax; Impact Analysis of Foreign Exchange Markets’, evaluates the impact of the proposed financial transaction tax on European FX markets, estimating its impact on FX cash and derivatives users. It suggests that a proposed tax would potentially result in relocation of 70-75% of tax eligible transactions outside of the EU tax jurisdiction; combined with reduced transaction volumes (of approx 5%), this could reduce market liquidity and increase indirect transaction costs by up to a further 110%.

The report not only recognises a primary impact of the tax – an increase in transaction costs, relocation of trading and reduction in notional turnover – but also a secondary impact, namely, a potential reduction in liquidity leading to a widening of bid/ask spreads. Source.

Reaction to the Proposal

A recent announcement by President Sarkozy about his plans to introduce tax on financial transactions this year has prompted a new wave of discussions among European leaders, central banks and financial community. Sarkozy said that France would implement the 0,1 percent financial transactions tax on trading in stocks, impose special levies on naked credit default swaps – or debt insurance not backed by ownership of the underlying debt – and high frequency trading, starting from August 1st. He expects the tax would raise 1 billion euro a year to be used to reduce France’s budget deficit in the face of slowing growth this year.

Sarkozy also mentioned that he hoped his announcement would push other countries to take action — if necessary even without UK, which has strongly resisted such measures.

Britain’s Prime Minister David Cameron last month said that to even consider the transactions tax “at a time when we are struggling to get our economies growing is quite simply madness.” EU estimates “showed a financial transaction tax could reduce the GDP of the EU by 200 billion euro, cost nearly 500,000 jobs and force as much as 90 percent of some markets away from the EU,” Cameron said. (Source: http://www.bloomberg.com/news/2012-02-06/eu-transactions-tax-will-hit-hardest-in-london-item-club-says.html)

The Dutch Central Bank estimated that a European financial transaction tax would cost the nation’s lenders, pension funds and insurers about four billion euro. Therefore, last week the Central Bank said it opposes the introduction of the tax, since it would hurt economic growth. Source.

Critics of financial transaction tax fear considerable negative effects. They argue, there is a danger not only of a permanent migration of financial transaction volumes away from Europe to preferred tax jurisdictions, but also that the tax is likely to reduce EU taxpayers’ savings and pensioners’ incomes, lead to a reduction in the level of investment in the real economy, send asset prices lower, widen spreads and increase market volatility.

Supporters of the tax argue that the financial transaction tax in the form the EC is proposing, will not damage European competitiveness. Algirdas Semeta, European Commissioner for taxation, customs, anti-fraud and audit, said that It will not destroy jobs neither will it be a backdoor way of increasing the EU budget. Much of the revenue would go directly to member states. The part for the EU budget would be offset by reductions in national contributions.

He also mentioned that strong mitigating measures are included in the EC proposal to prevent financial operators deciding to relocate: the low rate, wide base and, crucially, the “residence principle”. Mr Semeta said that “if banks and other players want to avoid the financial transaction tax, they would have to abandon their European clients altogether – an unlikely response to a small tax of 0.1percent on shares and bonds and 0.01percent on derivatives”. Source.

Some experts say that the financial transaction tax is designed to give the EU direct taxation powers on member states, which their respective parliaments cannot veto – something they cannot do under current law.

Concerns have also been raised that a system of individual transaction tax may be significantly more difficult to administer than the balance sheet approach, i.e. keeping record of each transaction rather than a singular view at the end of the financial year.

Implementation of a EU-wide financial transaction tax would require the support of all members of the European Union. However, the Eurozone could impose such a tax if support across the EU is not available. EU finance ministers are scheduled to discuss the levy in March.

Article written by Ekaterina Gloersen, a guest contributor to ForexMagnates.

Twitter: @kate_gloersen







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2 Comments on this post

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  1. Andy said:

    If i’m not mistaken, the commission proposal would explictly exclude spot FX from the tax.

    February 15th, 2012 at 2:36 pm
  2. Author said:

    While spot foreign exchange would be exempt from the tax, forex swaps and forwards would be included as cash products and forex options as derivatives. Foreign exchange swaps are the most actively traded foreign exchange instrument by far. According to BIS report (2010)”Reported foreign exchange market turnover by instrument”: spot FX is 37.4%, outright forwards and FX swaps 56.3%, options and other – 5.2% (http://www.bis.org/publ/rpfxf10t.pdf (p. 10)). Also, non-financial customers have only around 13% of daily turnover. Now, one can argue that even though spot FX would be exempt from the tax, there could be a chance that the FTT cost incurred by financial institutions (e.g. liquidity providers) could be passed on indirectly to spot FX.

    February 15th, 2012 at 5:23 pm

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