A European Commission variant of the Tobin tax to be implemented despite poor historical experience

Currently at least eleven EU member states have announced that they intend to implement a financial transactions tax (“FTT”) along the lines previously suggested by the European Commission. According to the proposal, the tax rate is intended to be 0.01 per cent for derivatives products and 0.1 per cent for other financial instruments (bonds and shares). The FTT will also impact investment firms and investors from nonparticipant countries. The main objective appears to be to generate tax revenue rather than reduce market volatility. Significantly, previous attempts to introduce financial transaction taxes have met with little success with actual tax revenue raised far less than expected due to relocation of trading. The measurable effect on market volatility has been unclear. Money market funds will be disproportionally hit by the FTT due to their frequency of trading. Moreover, the European Commission is in fact well aware of these problems which have been identified in previous analyses.
THE ORIGINAL TOBIN TAX. The original “Tobin tax” was suggested by the American economist James Tobin in 1972 and later presented in more detail in Tobin (1978); see reference list. He suggested a new system for international currency stability, of which an international charge on foreign-exchange transactions was a key component. Its objective was to reduce exchange rate volatility by levying a small tax on all spot conversions of one currency into another, penalising very short-term investments. The intention was to reduce harmful speculation by “throwing sand into the wheels of foreign exchange markets”. The aim of the tax was not to create revenue but to limit exchange rate fluctuations.


James Tobin (1918-2002)

THE EUROPEAN COMMISSION “TOBIN TAX”. The term “Tobin tax” is sometimes used to describe a more general type of financial transaction tax (“FTT”). The present European Commission’s current FTT proposal is of the general type and differs substantially from Tobin’s original tax, both in objective and design. The underlying analysis is presented in European Commission (2011). The proposed tax has three main objectives: to raise revenue; to reduce “overly risky” activities by financial institutions; and to avoid fragmentation of the internal market for financial services which could result from uncoordinated national taxes. However, the European Commission communication suggests its main rationale is to generate tax revenue, forcing the financial sector to contribute more to meeting the costs of the financial crisis. In other words, the aim of the tax is not, as originally intended, to dampen excessive market volatility. Interestingly, Tobin’s proposal was never about creating tax revenue. Details on how the tax will work are still largely unclear; the design of the FTT will be prepared only after approval for an enhanced co-operation procedure (see below) has been given but is intended to be based on the European Commission proposal. However, as far as the rate is concerned, it differentiates between different groups of instruments at 0.1 per cent for bonds and shares and 0.01 per cent for derivatives products. Spot currency transactions are excluded but derivatives agreements based on currency transactions are covered. Capital-raising (including issues) by companies or public authorities is not covered. In each case, a transaction will be taxed if one of the parties to it is a resident of a country signatory to the agreement. This implies

This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document Changes may be made to opinions or information contained herein without notice. Any US person wishing to obtain further information about this report should contact the New York branch of the Bank which has distributed this report in the US. Skandinaviska Enskilda Banken AB (publ) is a member of London Stock Exchange. It is regulated by the Securities and Futures Authority for the conduct of investment business in the UK.

Economic Insights

that a financial institution resident in a country where the tax has not been adopted must still pay it if other parties to the transaction are resident in countries that have adopted it. It has been proposed that the majority of the revenue generated will flow into the EU budget, although this is still subject to discussion. The European Commission forecasts total receipts of EUR 57bn annually if the tax were to be applied across the entire EU although it expects proceeds of around EUR 10bn if it is applied in only 11 countries. IMPLEMENTING THE TAX. While the financial crisis has emboldened those advocating FTTs, the European Commission’s original hope that all 27 member states would adopt the tax was far fetched. As EU member states may veto most tax issues it has proved impossible to implement an EU-wide FTT, due to opposition from the UK, Sweden and several others. Instead, currently eleven states of the 27 EU member states (Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Spain, Slovakia and Slovenia.) have announced that they want to implement the tax amongst themselves through enhanced cooperation. The requirement for such a procedure is that at least nine states participate. The European Commission has determined there are no legal obstacles to adopting the tax and the EU-parliament has approved its introduction. Next step is a vote by the Council in January 2013. The vote is likely to pass (a qualified majority is necessary) and will be followed by the European Commission presenting the final FTT proposal. The actual design of the FTT will not be known in detail until then. Timing is uncertain but the tax is expected to become law somewhere in the range 2014 to 2016. This would be the first time ever an FTT has been implemented operating across national borders. PREVIOUS EXPERIENCES ARE POOR. Sweden’s experience of an FTT is instructive and highlights several related problems. Between 1984 and 1991 an FTT was implemented in Sweden beginning with the introduction of a tax on the purchase and sale of equities, followed later by taxes on fixed-income securities. The most fundamental problem of Tobin taxes is that the introduction of a tax causes transactions to be relocated to other jurisdictions. Certainly, Tobin suggested such a measure would need to take the form of an internationally agreed uniform tax. In Sweden’s case, transactions simply moved abroad. Bond trading volumes fell by over 80 per cent and the options trading market disappeared. Correspondingly, tax revenues were much smaller than anticipated. The expected increase in receipts did not materialise and revenues were SEK 80mn rather than the SEK 1.5 bn expected. Similarly, current European Commission

revenue projections are likely to prove far too optimistic. As far as market volatility is concerned, evidence that a tax would reduce volatility is weak at best. Most empirical studies have failed to find a statistically significant causal link between increases in transaction costs and reductions in volatility. Lower liquidity could actually increase volatility. A transaction tax, depending on its design, could eliminate day-to-day low-margin trading while still failing to prevent speculation where expected profit widely exceeds the tax payable. Other problems include the incentive for market participants to innovate avoidance schemes including new financial instruments to avoid taxation, further reducing liquidity on the cash equities and fixed income markets. More generally, the tax also threatens to increase the cost of capital for business, as well as increase the cost of trading for institutional investors such as pension institutions, resulting in lower return on their investments. An FTT would therefore be harmful for the financial sector at a time when it is already suffering from limited activity. MONEY MARKET FUNDS WILL BE HARDEST HIT. Since the tax will be applied on a per transaction basis, money market funds will be especially hard hit. They invest in very short-term maturities, implying they are very frequent traders. Paradoxically, ‘safer’ fixed income portfolios investing in shorter duration bonds will be disproportionally hurt by the FTT. This is difficult to reconcile with the European Commission’s objective of discouraging ‘overly risky’ trading activities. THE EUROPEAN COMMISSION IS WELL AWARE OF THE PROBLEMS. Significantly, the European Commission’s own analyses acknowledge many of the problems and negative effects of an FTT. For example, it has already estimated a negative long-run effect on GDP of 0.5 per cent, assuming monies collected are invested in areas capable of stimulating growth. The Commission also acknowledges that the tax could distort the single market by creating incentives to relocate trading. European Commission (2005) argues that such relocation “could reduce the liquidity of some financial markets, which might even exacerbate their volatility”. Furthermore, European Commission (2011) states that full implementation by all EU member states is necessary to avoid distortions. As this is obviously not going to happen, the tax is therefore set to increase fragmentation of the internal market for financial services. Further, the introduction of the FTT, as stated above, will also impact investment firms and investors from non-participant countries, but the consequences are difficult to foresee at this stage without a proper draft proposal of the design.


Economic Insights

References European Commission (2005): “New Sources of Financing for Development: A Review of Options”, Commission Staff Working Paper, SEC (2005) 467. European Commission (2011): “Financing the EU Budget: Report on the Operation of the Own Resources System”, Commission Staff Working Paper, SEC (2011) 876 final. Tobin, J. (1978): “A Proposal for International Monetary Reform”. Eastern Economic Journal, 4(3-4), July/October, pp. 153-159.

Andreas Johnson SEB Economic Research + 46 73 523 77 25 andreas.johnson@seb.se


Sign up to vote on this title
UsefulNot useful