The Treasury: the case for a transaction tax

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The Treasury has published its review on the need for a Financial Transaction Tax. This is my take on the forty page document.

As it notes:

Perhaps of most significance from the perspective of creating moral hazard is the support offered to the financial sector as a whole in periods of financial instability. While the overriding objective of these actions is to minimise the impact of a potentially systemic crisis on the wider economy, the impact on market participants is inevitably also cushioned. Such actions create a presumption that the official sector will take whatever action is necessary to bail out the financial sector as a whole in bad times encouraging the markets collectively to take more risk and extend more credit in good times.

And as it says:

Even with measures in place to protect liquidity, deposits and capital, it is impossible to eliminate entirely the risk that the cost of stabilisation measures may have to be met out of exchequer funds. There is therefore a case for ensuring that in future the financial sector itself meets these residual costs to a greater degree.

One approach to ensure any residual exchequer costs are covered by the industry might be through a systemic risk levy or resolution fund. The levy might be charged on either a pre- or post-funded basis. It could be weighted towards financial firms, which because of their size or the nature of their business, were a potential source of significant risk to the stability of the financial system. The levy would not fund insurance for any individual firm but rather would support intervention, if needed, to stabilise the system as a whole.

In principle, a well-designed levy could achieve two objectives. It would both raise funds to cover the costs of restoring financial stability and, to the extent that the levy accurately reflected both systemic risk and institution-specific risk and charged for individual institutions’ contribution to those risks, it would embed incentives that would reduce the probability that such costs would ever materialise.

This being noted though it goes on to say with regard to tax:

There can be no doubt that there have been market failures in the financial system. The rising level of bank revenues reflects in part greater leverage and excessive risk-taking through investment in assets that were often opaque to shareholders and counterparties. These practices were encouraged by remuneration packages where rewards were directly linked to short term returns and in some cases were clearly inconsistent with prudent risk management. And at the height of the crisis there was the risk of a serious coordination failure between institutions and markets that required internationally co-ordinated intervention to resolve.

When there are market failures then the market outcome will not be to the full benefit to all in society. Policy intervention may therefore be needed to address market failures and correct distortion. Any policy instrument should as far as possible address the source of the failure but without encouraging behaviour that would either undermine the objective or create adverse unintended consequences. One possible lever to deliver these objectives is taxation. 

Enormous fiscal support has been extended to financial systems around the world at the cost of temporarily high fiscal deficits and debt to GDP levels. Consolidation of fiscal accounts as economies and financial systems recover will therefore be necessary as countries exit from these extraordinary measures. It is right that the financial sector should make a significant contribution to this.

From where it moves on to say:

A financial transaction tax is one proposal that has been put forward as a potential method of ensuring that the global financial services sector makes a fair contribution. One argument for taxing certain transactions is that some financial activities have little or even negative social value and therefore ought to be taxed. This has been proposed by Paul Krugman as a tax on speculators  and Adair Turner as a tax on socially useless activities. Another is that the revenues raised from a transaction tax could potentially be very large, although the tax would need to be designed to introduce minimal economic distortions.

In the past, financial transaction taxes have been discussed in the context of foreign exchange markets but the debate has since changed to other dimensions of finance. Concerns have been expressed at the rapid growth of some financial markets, particularly complex instruments with elaborate networks of counterparties, such as the growth of international over-the-counter derivatives illustrated in Chart 4.A. In the five years to mid-2008 the notional amount of contracts outstanding had increased four times to $683 trillion. Some of these contracts serve perfectly useful functions, but there are financial stability concerns around the rapid expansion of others. For example, the notional value of credit default swaps outstanding increased by nine times to their peak at the end of 2007.

As set out in the Prime Minister’s speech to G20 finance ministers at St Andrews, a financial transaction tax would need to follow four key principles: implemented at a global level; minimal distortionary impact; ensure financial stability; and be fair and measured.

As it then notes:

As well as considering the economic impact of a financial transaction tax, there are some significant issues to explore regarding its design and implementation. Key points include:  
Risk, reward and responsibility: the financial sector and society

‚Ä¢  Identifying the tax base: as discussed above, to protect against avoidance a financial transactions tax would ideally have as broad a base as possible, including over-the-counter transactions;
‚Ä¢  Establishing a means of tracking transactions in order to implement the tax, given financial transactions are currently recorded through a range of exchanges and other systems;
‚Ä¢  Setting a rate, or rates, to ensure the introduction of a financial transaction tax does not have a negative economic impact, given the different margins on particular types of transactions;
‚Ä¢  Determining a means for allocating revenue raised, given the international nature of many financial transactions; and
‚Ä¢  Defining a method for monitoring and ensuring compliance, and determining action that should be taken in the event of avoidance or evasion.

As outlined, there remain areas for further work on both the economic impact of a financial transaction tax, and how such a tax could be successfully implemented. It will be important that the IMF addresses these points in its report for the G20.

It then notes next steps, none of which, regrettably gives a clear commitment to action: the implication is that more work will be done in the UK to present to the IMF, EU and others to take this matter forward.

What to conclude? The fact that this paper has been published is good news. It is clear that the government wants to say ‘never again’. Much of the paper is an exposition of the risks that the finance industry creates: this is the argument for action. The feeling that there is an argument for action seems to be strong. And yet the case for change is not made clearly. But I suspect, very strongly, that was not the point of this paper now. It is intended as a signpost as to the future direction of UK thinking. And the fact that it is looking at a financial transaction tax may have to be good enough news for now. The gaps will be filled in later.