In a hedged and roundabout way, the Vatican has endorsed a financial transactions tax. The announcement came in a Note on financial reform from the Pontifical Council for Justice and Peace , which is one branch within the official governing structure of the Catholic Church. The Note advocates a \”world Authority\” and \”global monetary management,\” but also admits: \”However, a long road still needs to be travelled before arriving at the creation of a public Authority with universal jurisdiction.\” When the note gets down to more immediate suggestions, it offers three:
\”On the basis of this sort of ethical approach, it seems advisable to reflect, for example, on: a) taxation measures on financial transactions through fair but modulated rates with charges proportionate to the complexity of the operations, especially those made on the “secondary” market. Such taxation would be very useful in promoting global development and sustainability according to the principles of social justice and solidarity. It could also contribute to the creation of a world reserve fund to support the economies of the countries hit by crisis as well as the recovery of their monetary and financial system; b) forms of recapitalization of banks with public funds making the support conditional on “virtuous” behaviours aimed at developing the “real economy”; c) the definition of the domains of ordinary credit and of Investment Banking. This distinction would allow a more effective management of the “shadow markets” which have no controls and limits.\”
I will sidestep here the second and third points, on what it means to have \”virtuous\” bankers who develop the \”real economy\” and what kind of financial regulation is appropriate for all the institutions in a modern economy. But on the issue of a financial transactions tax, Thornton Matheson of the IMF offers a nice review of the economics of \”Taxing Financial Transactions: Issues and Evidence\” in Working Paper WP/11/54 released last March. Here are a few highlights (footnotes and citations omitted):
Financial transactions have increased substantially
\”Transaction costs have indeed fallen dramatically across financial markets over the past 35 years due to advances in information technology, deregulation, and product innovation. In the U.S. equity market, commission deregulation (1975) and decimalization (2000) both substantially lowered transactions costs. Bid/ask spreads on the NYSE now average about 0.1 percent, vs. 1.3 percent in the mid-1980s. In the foreign exchange market, bid-ask spreads for major currencies are currently as little as 1–4 basis points, half the level of a decade ago. Spreads in interest rate futures and swaps are also on the order of a few basis points. Development of the interest rate and credit default swap markets has enabled investors to tailor their fixed-income exposure more cheaply than by trading the underlying bonds.\”
\”As economic theory would predict, this steep decline in financial transaction costs has produced an increase in financial transactions relative to real activity. The value of world financial transactions, which was 25 times world GDP in 1995, rose to70 times that value by 2007. The growth of transactions has been concentrated in derivatives markets, which often have much lower transaction costs relative to notional values than spot markets. Growth in interest rate and equity derivatives transactions has far outstripped growth in business investment in North America and Europe, while the ratio of spot transactions to investment has remained fairly steady. As theory would also predict, lower transactions costs have particularly spurred short-term trading. The past decade has witnessed explosive growth in algorithm or computer-driven trading that relies on high-speed transactions. In 2009, algorithm trading accounted for at least 60 percent of U.S. equity trading volume (up from about 30 percent in 2006), and 30–40 percent of European and Japanese equity trading. Algorithm trading also accounts for 10–20 percent of foreign exchange trading volume, 20 percent of U.S. options volume, and 40 percent of U.S. futures volume.\”
Many countries already have some version of a financial transactions tax at a low level
In the United States, for example: \” The United States’ Securities and Exchange Commission (SEC), its equity market regulator, imposes a 0.17 basis point chargeon stock market transactions to fund its regulatory operations. … New York State levies a tax of up to five cents per share on within-state stock trades with a cap of $350 per trade …\” However, the trend in recent decades is that the level of such taxes has been dropping around the world.
The case for a financial transactions tax is weak
\”The potentially large base of an STT [security transactions tax] promises an opportunity to raise substantial revenue with a low-rate tax. Current estimates of the revenue potential of a low-rate (0.5–1 basis point) multilateral CTT [currency transactions tax] on the four major trading currencies suggest that it could raise about $20–40 billion annually, or roughly 0.05 percent of world GDP. A one basis point STT on global stocks, bonds and derivatives is estimated to raise approximately 0.4 percent of world GDP.
\”However, financial transactions taxes create many distortions that militate against using an STT to raise revenue. STTs reduce security values and raise the cost of capital for issuers, particularly issuers of frequently traded securities. STTs also reduce trading volume: studies of existing STTs and other transaction costs suggest that the elasticity of trading volume with respect to transactions costs ranges broadly between -0.4 and -2.6, depending on the market studied. Markets with products for which there are more untaxed substitutes, such as derivatives or foreign listings, have higher elasticities. Lower trading volume in turn reduces liquidity and slows price discovery.
\”An STT is also an inefficient instrument for regulating financial markets and preventing bubbles. There is no convincing evidence that STTs lower short-term price volatility, and high transaction costs are likely to increase it. Current economic thought attributes asset bubbles to excessive leverage, not excessive transactions per se. …
\”The short-run incidence of an STT would likely be quite progressive, as securities values fell in response to the tax. Financial activity, particularly short-term trading, would contract, lowering financial sector profits. Financial firms would likely pass the cost of an STT on surviving activity on to clients, which include not only wealthy individuals and corporations but also charities and pension and mutual funds. In the medium term, release of resources from the financial sector could lower the equilibrium return to highly skilled labor. In the long run, the burden of an STT depends on the elasticity of the capital supply: Like the corporate income tax, the higher financing costs imposed by an STT will fall more heavily on labor than on capital owners as the elasticity of the supply of capital increases.\”
This last argument points out that in the long run, if a financial transactions tax makes it more costly to raise capital, then it will lead to a capital stock that is lower than it would otherwise be. As a result, workers in that country who have less capital with which to work will end up bearing the burden of the tax.
If the goal is to discouraging asset bubbles, tax changes to discourage leverage are more appropriate
\”To discourage leverage at the institutional level, a tax on balance sheet debt (net of insured deposits and equity), such as the financial sector contribution (FSC), could be used. The FSC could be tailored to tax systemically important institutions more heavily, since their risks pose a greater danger to the broad economy. Another means of combating leverage at the firm level is reform of the corporate income tax (CIT), which
encourages debt over equity finance due to its disparate treatment of interest and earnings. To discourage debt finance while raising revenue, interest deductibility could be reduced or even eliminated, as in a comprehensive business income tax …\”
If the goal is to raise tax revenue from the financial sector, think VAT or FAT
\”To tax the financial sector, the base of an existing VAT [value-added tax] could be broadened to include fee-based financial services, or an FAT could be introduced.\” A FAT is a “financial activities tax,” which would be levied on the sum of financial institutions profits and wages.