Is a financial transactions tax a silver bullet?

Every time we discuss new taxes, people raise the possible alternative of a financial transactions tax. Known by some as a Robin Hood Tax, or a Tobin tax, the FTT would put a small charge on every financial transaction made. It is gaining in popularity around the world and while it could theoretically work if all countries adopted it, so far the results from individual experiments have been far from impressive.

But before we look at the results, we should start by asking why some people want to tax transactions at all.

Why do we want to tax transactions? 

Placing a tax on a specific action can raise money but it also discourages that behaviour. Sometimes that is a bad thing, and sometimes it is a good thing. Taxes on income, for example, raise a lot of money but also dent the incentive to go out there and earn income, which reduces output and creates a loss to society. The government is betting that voters will be happy to have more government services than income in the pocket. Taxes on pollution, on the other hand, can raise money but also reduce pollution at the same time – creating a win/win for society – providing the cost of the pollution-heavy goods don’t rise too much. If taxing financial transactions leads to fewer of them, will we be better or worse off?

Some are convinced New Zealand would be better off. They think that bankers and traders are getting more than their fair share of benefit out of the globalised economy, that speculation is excessive, this is contributing to the greater volatility and uncertainty in markets so Kiwis are worse off. Given the billions that pass through the financial sector every day, the idea is that clipping the ticket on each transaction would raise a lot of money and reduce both speculation and volatility in financial markets.

However, not all transactions are bad – when you get paid, for example, or make a payment on your mortgage. Or send money overseas to pay for your upcoming holiday. Would you mind someone clipping the ticket on all of those? Of course, you can specify what kinds of transactions you want to target with a tax, such as house sales (via a stamp duty) or share trades or foreign currency deals. But ordinary people still engage in all of those, at the very least through KiwiSaver.

Sure, some transactions are purely speculative, but an FTT won’t just stop those. It is a sledgehammer and would not discriminate between ‘good’ and ‘bad’ financial transactions.

Impact of an FTT on transactions
One development that has made the FTT easier to implement is the automation of many financial payments, making it difficult to avoid, at least in the jurisdiction in which it’s applied. On the other hand, the increased complexity of international markets means it is easier for financial institutions to re-route their transactions beyond that jurisdiction simply to avoid the tax. The FTT then would be most effective if applied worldwide.

In the absence of international consensus, a lot depends on the design of tax. Perhaps the most well-known and successful FTT is stamp duty, which in some countries (such as the UK) is levied on house sales. This is typically paid as a percentage of the total house price, which distinguishes it from a capital gains tax. Given the size of the transaction, it is hard to get around paying the tax. Stamp duties are fairly well researched and provide a useful example of the impact of a FTT on a market.

Research has found that (unsurprisingly) people respond to FTTs such as stamp duty by reducing the number of taxed transactions made. In other words, house sales drop. This doesn’t alter the intent of transactions, simply the number. Stamp duty hasn’t prevented speculation on housing, nor reduced volatility in the market. Quite the contrary, having fewer transactions can increase the volatility in the market. Fewer transactions can also have their costs in terms of the efficiency of the economy. Stamp duty, for example, makes it more likely for an elderly person to hold on to a home that is too large for them, and therefore makes it more difficult for families to find the houses they need.

Gathering revenue
Perhaps the biggest disappointment of the FTT has been on the revenue generation side. Brookings estimate that in the US a FTT could generate around 0.4% of GDP. That isn’t a huge amount; the New Zealand equivalent would be about $1b. The only way to get more revenue would be to have a higher tax rate on each transaction, which is really impossible if tax dodging is to be avoided, without some global consensus on applying the tax.

The experience of Sweden’s FTT has been interesting. When it was introduced, revenue was far lower than predicted because of changes in the number of financial transactions. In fact, the lower number of transactions reduced revenue from Sweden’s capital gains tax, so the government ended up with less revenue overall.

Won't work
In short, the FTT appeals mainly to those who seek to get at “wicked bankers and evil speculators” but it’s pretty naive. It is unlikely to raise a lot of money unless there is a global agreement; otherwise it would leak like a sieve, penalise quite innocent and necessary trade, impede economic activity unnecessarily – all features of a bad tax. In the meantime, taxes like the comprehensive capital income tax (CCIT) seem to have much more potential to raise serious revenue and benefit the economy by closing existing tax loopholes.

Geoff Simmons is an economist working for the Morgan Foundation. This post first appeared on Gareth's World.

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