The Curious Case of Transaction Taxes
1 November 2011
The issue of Financial Transaction Tax (FTT) has come to the fore in the aftermath of the financial crisis. The main motivation behind such a tax is to curb speculative flow of international financial capital. It also has the potential to generate substantial revenue which can be used to fund social development, particularly in developing countries. According to estimates by Bill and Melinda Gates foundation, FTT can raise about $50 bn from G-20 member countries, while according to other estimates FTT can raise $250 bn if a wide range of transactions are included. Implementation of such a tax would also help in monitoring of cross country flows through centralized database; this will also make evasion of such tax difficult. Such a tax to discourage speculation in short term international transactions, also known as Tobin Tax, was proposed by James Tobin in 1972. Opponents of FTT argue that this tax would increase transaction cost thereby reducing efficiency and market liquidity. Moreover, if different countries apply different tax rates, that will result in unwarranted trading volume flows from countries with higher taxes towards countries with favorable tax regime. Needless to say, implementation of such a tax is contingent on agreement reached by the major countries, namely the G20 countries. In September 2011, the European Commission (EC) backed the adoption of an EC proposal to implement FTT in all 27 member-states of the European Union (EU). This tax will be levied on all financial transactions if at least one of the parties involved in the transaction is an EU country. According to this proposal, trading on stocks and bonds will be taxed at 0.1% while derivative trading will be taxed at 0.01%. Individual EU countries may charge higher tax. If approved, this will be effective from 2014 and is estimated to raise $78 bn a year. This proposal has the backing of the two major EU nations, Germany and France, while the United Kingdom (UK) has expressed its reservation over it. British government’s position is that they would back FTT only if it is applied globally; otherwise, it fears, London, a major financial hub, will lose out to New York and Hong Kong in competitiveness. Similarly other countries like U.S., Canada and Australia have also resisted the idea of introducing FTT. Among the emerging nations, Brazil and South Africa have backed the introduction FTT, but India has expressed its reservations against it. India says this tax would be an additional burden on Indian banks which are mandated to set aside significant amount of funds to meet regulatory requirements (i.e., maintain cash reserve ratio and statutory liquidity ratio). India’s position is interesting on two counts. In 2003, India had backed a similar idea to introduce an ‘international levy’ to prevent ‘unstable capital flows’ which ‘can severely disrupt developing economies’. Such a tax was then considered to be ‘an instrument to protect weak economies from the volatility of capital … and to generate valuable developmental resources’. Secondly, in 2004, India itself introduced a similar measure, the Securities Transaction Tax (STT), in its equity and derivative market – this is a tax levied from traders, domestic and foreign, on all transactions that happen in these two market segments. The motivation behind the introduction of STT was pretty similar too, i.e., generating extra tax revenue and protecting market integrity. While it is debatable if this tax has been able to rein in speculation in the markets, it can be safely argued that this has not resulted in significant drying up of liquidity in the markets, as had been originally feared. Additional revenue generated due to this tax contributed to around $1.5bn to the government’s exchequer last year. However, the capital market regulator, the Securities and Exchange Board of India (SEBI), the exchanges, brokers and investors are in favor of abolishing STT. They believe the cost of transaction in India is high; they expect abolition of STT will positively impact the market turnover as lower or no STT would help in higher algorithm trades high frequency traders in driving up trading volumes. SEBI is currently reviewing the impact on the stock market turnover from a possible scrapping of STT and would submit its findings to the Finance Ministry who will take the final call regarding this issue. The Finance Ministry's capital markets division is said to be in favor of reviewing the STT framework with a view of either scrapping it altogether or in a phased manner, but a final call is unlikely to be taken before the next budget. All these decisions, be it for FTT or STT, effectively come more under the purview of political agents and governments than regulators or technocrats. While the FTT issue is likely to be again discussed in next G20 meeting, decision on STT is likely to be announced by next Indian budget. Hence, their acceptance or rejection will largely depend on the political environment that is to unfold in the next few months.