Since September 2011, the European Commission has been proposing a transaction tax that aims to make the financial sector pay for state support and state guarantees during the financial and economic crisis from 2007 until 2009. However, the United Kingdom, the Netherlands, and some other European countries have rejected this idea. The argument of the critics is common knowledge; they argue that such a tax can only be effective if it is introduced on an international level. Otherwise the financial transactions would simply move to countries and financial centers without a transaction tax.
In an economic sense this might be correct because capital is quite mobile. Another drawback of a transaction tax is that the customers have to pay the bill, not the traders or bankers. To put it simply; the steering effect of this tax is inappropriate if implemented nationally. But we can also make the economic argument that it is important to reduce the volatility and contagious effects of high frequency trading. A transaction tax on derivatives would have at least the potential to reduce these effects a little bit. But to be effective it still requires a European or at best an international implementation.
As a result of the political disagreement in Europe, the German Finance Minister Wolfgang Schäuble has now expressed cautious support for a tax on stock trades – similar to the UK stamp duty reserve tax – before broadening the tax base at a later date. This would entail a tax payable on all transactions involving shares of corporations listed on a stock exchange, with the tax being levied according to the place where the corporation has its registered office. According to Schäuble, negotiations on the Commission’s proposal for a common system of financial transaction tax should not be abandoned or postponed.
What are the pros and cons for such a tax model? In 1986, the UK ratified the Finance Act and introduced the Stamp Duty Reserve Tax (SDRT) at a rate of 0.5% on share purchases. The revenues average 3.8 billion Euros per year, of which about 40% is paid by foreign residents. The tax is charged regardless of whether the transaction takes place in the UK or overseas because it is levied to the location of the corporation. This means that the SDRT is paid by foreign and UK-based investors who invest in UK companies, and thus it is similar to a standard stamp duty tax. However, the revenue is highly pro-cyclical with economic activity. In the UK, the highest revenues were during the dot.com boom (about 5.4 billion Euros) and dropped in the financial crisis years of 2008 and 2009 to 3.7 billion Euros.
Two advantages of the SDRT over a transaction tax are that it would be less economically costly, and it would have fewer detrimental effects on financial markets. The SDRT approach is also more pragmatic, and a Europe-wide implementation might be acceptable to politicians in London. But there are two negative points as well: One, this tax does not target the immense daily trading volumes in unregulated derivates markets. Two, the steering effect of the SDRT is lost when most shares are traded over the counter and not at the stock exchange – as is the case today. The lessons of the past years demonstrate that both these arguments should lead us to favor a transaction tax over the SDRT.
The idea proposed by the German Finance Minister is well-intentioned but poorly thought through. If he really wants to pursue his plans, Schäuble first needs to regulate the derivates market. A European regulation has the advantage that the derivate products would become more standardized and transparent for taxation. A tax on stock trades, or a tax modeled on the British SDRT, does not solve the problem. This “stamp tax” will have no sizeable steering effects and is not effective, as demonstrated by the financial mess especially in the UK.
The best solution is still an international transaction tax on all traded products. Empirical evidence indicates that all countries would benefit from such a global transaction tax. Today countries do not internalize the costly effects of financial instability and the negative feedback effects due to highly sophisticated and interconnected derivative markets. This is the main lesson policymakers have to draw on the past financial crisis!
Read more in this column Bodo Herzog: The False Appeal of Central Banks