The Great Debate

The wrong tax for Europe

By Kenneth Rogoff
October 3, 2011

By Kenneth Rogoff
The opinions expressed are his own.

Europe is already in a pickle, so why not add more vinegar? That seems to be the thinking behind the European Commission’s proposed financial transactions tax (FTT) – the Commission’s latest response to Europe’s festering growth and financing problems.

The emotional appeal of a tax on all financial transactions is undeniable. Ordinary Europeans have to pay value-added tax on most of the goods and services that they buy. So why not tax purchases of stocks, bonds, and all kinds of derivatives? Surely, such a tax will hit wealthy individuals and financial firms far more than anyone else, and, besides, it will raise a ton of revenue.

Indeed, the European Commission estimates that its proposed tax of only 0.1% on stock and bond trades, and 0.01% tax on derivatives, will raise more than €50 billion per year. As a bonus, an FTT will curb destabilizing speculation in financial markets.

If only it were so simple. Of course, taxation of financial firms’ profits and bonuses should be made more similar to that of other economic activities. Excessive leverage needs to be reined in. A return to pre-2007 levels of macroeconomic and financial stability would support growth. Unfortunately, as much as FTTs are the darling of leading liberal economic commentators and Robin Hood NGOs, they are an extremely misguided approach to achieving such worthy ends.

True, great thinkers like John Maynard Keynes and the late Nobel laureate James Tobin floated various ideas for taxing financial transactions as a way to reduce economic volatility. (Tobin’s tax applied specifically to foreign-exchange trading.) But, since then, the idea has received close attention from many economic researchers, and, frankly, it is hard to find their research results supportive.

Such taxes surely reduce liquidity in financial markets. With fewer trades, the information content of prices is arguably reduced. But both theoretical and simulation results suggest no obvious decline in volatility. And, while raising so much revenue with so low a tax rate sounds grand, the declining volume of trades would shrink the tax base precipitously. As a result, the ultimate revenue gains are likely to prove disappointing, as Sweden discovered when it attempted to tax financial transactions two decades ago.

Worse still, over the long run, the tax burden would shift. Higher transactions taxes increase the cost of capital, ultimately lowering investment. With a lower capital stock, output would trend downward, reducing government revenues and substantially offsetting the direct gain from the tax. In the long run, wages would fall, and ordinary workers would end up bearing a significant share of the cost. More broadly, FTTs violate the general public-finance principle that it is inefficient to tax intermediate factors of production, particularly ones that are highly mobile and fluid in their response.

All of this is well known, even if prominent opinion leaders, politicians, and philanthropists prefer to ignore it. The European Commission has surely been strongly cautioned by the Fiscal Affairs Department at the International Monetary Fund, whose economists have thoroughly catalogued the pros and cons of FTTs. So why did the Commission go forward with the idea?

The most generous interpretation is that the Commission simply does not believe economists’ estimates and analysis, and views an FTT as more workable than is commonly realized (a scenario that calls to mind the debate surrounding the creation of the euro.) It is true that Latin American governments, particularly the Brazilian authorities, succeeded in raising more revenue from taxes on bank withdrawals (a crude version of an FTT) than most policy analysts thought possible. On the other hand, Latin America’s long-term growth record is hardly an advertisement for the approach, and accounting for lost tax revenues due to lower GDP would surely yield a less impressive fiscal outcome.

Another possibility is the Europeans concluded that an FTT’s political advantages outweigh its economic flaws. After all, there certainly is a case to be made that an FTT has so much gut-level popular appeal that politically powerful financial interests could not block it. One can almost buy this idea, except that the tax is so counterproductive in the long run that it is hardly obvious that it would be better than nothing.

There are more cynical interpretations of the European Commission’s motives. Perhaps officials noticed that virtually everything in Europe is already heavily taxed. So, rather than finance the European Union’s institutions through greater contributions from existing tax bases, they are seeking a consensus for new revenue sources. Or perhaps the Commission realizes that the FTT will be dead on arrival, owing to disputes within Europe, and simply wants to gain political capital from an enormous popular proposal.

After the financial crisis erupted with full force in 2008, former US Federal Reserve Chairman Paul Volcker claimed that the only worthwhile financial innovation in recent decades was the ATM. And, as the Oscar-winning documentary Inside Job rightly points out, no one whose other, less useful innovations helped cause the financial crisis – politicians, financiers, and many others – has really paid a price.

There is, in short, ample reason to be angry at financiers, and real change is needed in how they operate. But the FTT, despite its noble intellectual lineage, is no solution to Europe’s problems – or to the world’s.


13 comments so far | RSS Comments RSS

An apologist for the bankster class, so sad…

The professor says with a Tobin Tax would result in fewer trades: “With fewer trades, the information content of prices is arguably reduced.” — I suppose this silly argument means HFT, where the banksters get information a priori and stand between buyers and sellers, skimming pennies, is a good thing. Professor, does HFT reduce volatility?

Time has come to rein in the bankster class. Banks should be run as regulated utilities, not casinos where the public bails out the losers.

Suggestions that the bankster class not pay a transaction tax could only come from the rarified airs or academia or think tanks. Group think from those venues has only legitimized the looting of the assets of the other 99%. Haircuts are in order for the 1%

Posted by upstater | Report as abusive

From a practical political perspective, FTT will certainly be supported by the European Parliament and it may be implemented by EU-17 principally because of UK and City opposition. Sweden tried it long ago but failed to make it work to their fiscal advantage.

What is rather important to understand, right now, is the Commissioner Banier responsible for banking sector euro-wide will be proposing restructuring and further oversight mechanism to curtail HFT and turbo-capitalism.

Posted by hariknaidu | Report as abusive

The FTT proponents theories and calculations always fail when when reality is applied to them. Sweden realized 3 percent of their FTT revenue projections-before subtracting revenue losses the tax created in many other areas. The two great promoters of this failed tax abolished theirs. Germany in 1991, France in 2008. James Tobin himself later in life said his Tobin Tax would not work. A few banks helped create the crisis, so what do the proponents do? They raid pension funds, investors, savers with this tax. There is little more disgusting than that.

Posted by rhone | Report as abusive

It’s not going to happen in the EU. The UK, Sweden, the Netherlands, Ireland, the Czech Republic, and Malta are all against the tax. The EU’s own “Impact Assessment Report” showed that the EU FTT would cost more in lost GDP than it would generate in taxes. That pretty much sealed the deal.

Posted by TommyAD | Report as abusive

City of London officials pointed out as soon as this was mentioned that 80% of the revenues from such a tax would come from the City of London. This is what Manuel Barroso means when he says,
“We have to understand we are in a situation where we have to do things together”. “Together” means the southern Europe bands together to ambush northern Europe with plans for what amounts to a heist, and hope they don’t notice until it’s too late…
http://www.bbc.co.uk/news/business-15090 761

If implemented, the poor might decide that banking is too expensive and start trading in cash again instead, shifting a large part of the economy back off the radar. Still, one might well expect impractical populist “anti-bourgeois” legislation to be promoted by a Commission President who spent his youth in the Portuguese Workers’ Communist Party.

“…perhaps the Commission realizes that the FTT will be dead on arrival, owing to disputes within Europe, and simply wants to gain political capital from an enormous[ly] popular proposal.”
- Perhaps so. The Commission is either allowing sheer greed to get the better of their senses, or actually anticipates that British officials won’t stand for this and will attempt to use this idea to:
1. Earn popularity with illiterate, frustrated workers;
2. Push Britain into a corner politically;
3. Table the motion knowing it will be vetoed, only to use it as a political bargaining chip, using the withdrawal of the hopeless motion to extract other financial or political concessions from the United Kingdom.

Only, this plan will not work. In Britain, almost all consumer banking is currently free. If the European Commission forces a situation where banks must start charging us fees for everything, this will not be taken kindly by the average British consumer. Even those who make almost no bank transactions will still hate the European Commission for stealing some of their meagre funds.

The suggestion is completely idiotic and self-defeating – if Barroso continues pushing this policy, he’ll only popularise anti-EU political parties in the UK. But who can tell the European Commission?

Posted by matthewslyman | Report as abusive

I just mentioned in my last post: President José Manuel Barroso (of the European Commission) was a Communist in his early years, and appears to remain so in his heart.
http://en.wikipedia.org/wiki/Jos%C3%A9_M anuel_Dur%C3%A3o_Barroso

The thing that’s totally wrong and characteristically Communist about this new FTT (financial transactions tax) plan is that it’s designed to confiscate money from anybody who has it, no matter what they’re doing with it; as though anybody who has money (especially if they’re “trading” it as working capital within a productive and useful business) is somehow morally obliged to “share” it with the “rest of us”, who are of course entitled to a cut of that money.

The hoarding of liquid assets by the wealthy is a major component of the current crisis, and one of the biggest current sources of instability. The lack of meaningful investment by the rich, who are all simultaneously attempting to stash all their assets in “safe” commodities and currencies, is probably the biggest source of imbalance in the system right now; apart from the Western structural deficits and the lack of adequate regulation within certain politically well-connected industries. A tax on financial trading can only worsen and prolong this crisis; encouraging the wealthy to shift almost all of their remaining working capital into “safe” commodities before the tax takes effect, and then keep their assets (e.g. gold) under lock and key until the market starts visibly coming back to life.

Flawed and selfish logic from all sides, and surely a recipe for financial disaster.

Posted by matthewslyman | Report as abusive

One more possible effect of such a tax (if actually implemented, which is politically impossible) might be flight of capital and taxable business out of Europe (which would be particularly unhelpful at this juncture). This would be caused by the departure of financial services companies, and would surely precipitate the current recession into a full-blown depression.

Warren Buffett is right to suggest that good businessmen don’t ignore a sound business investment because of taxes; however, as one successful chief executive once said to me:
“I don’t want to have to think about how much I’ll need to pay in fees, every time I go to the toilet.”

I can’t think of a single good thing that can possibly come of this crazy idea.

Posted by matthewslyman | Report as abusive

HOWEVER: Here’s an article from BBC’s Robert Peston, explaining how this FTT might actually be beneficial if carefully designed and implemented (just discovered this):
http://www.bbc.co.uk/news/business-15148 590

Posted by matthewslyman | Report as abusive

Yes, a financial transactions tax is a great idea in both Europe and the USA.

In addition, a possession tax for derivatives of 3% per year would be healthy. Derivatives are as dangerous as sawed off shotguns and machine guns. Tax them out of existence.

Most of the ills of the modern world are caused by deceptive, complex financial devices. Obliterate them.

Posted by txgadfly | Report as abusive

Just imposing new taxes to cover over the holes left by the EU for poor judgement and economic and political mismanagement won’t do.

The EU simply cannot blame the financial sector for the problems experienced this year. They allowed Greece et al into the single currency despite the fact that allowing them entry broke all of the ‘golden’ rules. This is sovereign debt crisis brought about by the EU.

If the EU continues the way that they are going, there will be little or no commerce left within the EU zone. And why on earth the UK should pay for this with a GFT is beyond me.

Many of our pension plans use OTC inflation and interest rate (and credit default) swaps as part of their asset/liability (LDI) matching solutions. These swaps are used to HEDGE exposure and risk not to profit by taking massive risks.

The EU clearly has little or no understanding of finance. Just when exactly are they going to get the last 16 years of accounts for the EU budget audited?

People who live in glass houses should not throw stones.

Posted by SCSCSCSC | Report as abusive

Response not from a “liberal economic commentator”, but from a former Managing Director of JPMorgan, and Member of Long Term Capital Oversight Committee:

Dr. Rogoff is right that FTT will not impose justice on banks.

Dr. Rogoff is right that the revenue potential is probably overstated, although the academic studies i’ve seen attempt to adjust for the volume impact of the tax.

Dr. Rogoff confuses transactions costs of secondary trading with cost of capital. At the very most, this has a remote second order affect, swamped in my judgment by the affect of lost market resiliency and reduced trust which hurts all companies via much higher cost of capital. Ask any small business about their cost of capital today as a result of the financial collapse. Lost market resiliency trumps market efficiency in a non-linear way. Market resiliency has a cost of efficiency – a tradeoff well understood in natural systems science.

Dr. Rogoff falls into the trap of “liquidity must be better” argument. Not all liquidity is created equal (Buffett liquidity for Goldman in the crash far different than liquidity of 4000 trades per second with leveraged capital), and even if it were, if greater liquidity comes at the expense of resiliency, at some point it harms economic efficiency (as apposed to market efficiency).

Excerpts from http://capitalinstitute.org/blog/taming- casino

“A FTT will not provide justice, nor will it address the unchecked power of mega-banks.”
“A FTT should rather be understood as a laser-sharp policy intervention that will combat (not fix) one of the most corrosive realities undermining capitalism itself: short-term speculation has displaced real investment, transforming our economy into a bankrupt financial system that lacks morals and purpose.”
“Confusion about the impact of a FTT on economic growth…rests on two misunderstandings:
1. First, because the economic system has effectively become a (misguided) financial system, opinion leaders get lulled into confusing financial market efficiency with economic efficiency.
2. Second, systems scientists understand (but economists often don’t) that any system must balance efficiency with resiliency in order to be sustainable.


Posted by jfullerton | Report as abusive

The European Commission’s own “Impact Assessment Report” for the financial transaction tax (FTT) concludes that there will be an annual GDP loss of 0.5 percent. That’s the equivalent of €61 billion or 500,000 lost jobs. Under their own best case scenario, the FTT will only raise €57 billion. The Czech Republic’s Finance Minister said that it was “irrational” to support a tax that decreases GDP, loses more revenues than it raises, and is likely to cost over 500,000 jobs.

Here’s the most important question: Who bears the burden of the FTT? The banks? Or the 500,000 people who don’t have jobs as a result of the tax?

Posted by TommyAD | Report as abusive

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