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Wrong Tax For Europe

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

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 per cent on stock and bond trades, and 0.01 per cent tax on derivatives, will raise more than €50 billion per year. As a bonus, an FTT will curb destabilising speculation in 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, 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.

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 trade would shrink the tax base. As a result, the ultimate revenue gains are likely to prove disappointing.

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 been cautioned by the Fiscal Affairs Department at the International Monetary Fund, whose economists have catalogued the pros and cons of FTTs. So why did the commission go forward with the idea?

The most generous interpretation is that the body does not believe economists' estimates, and views an FTT as more workable than is commonly realised.  It is true that Latin American governments succeeded in raising more revenue from taxes on bank withdrawals than most analysts thought possible. On the other hand, the region's long-term growth record is hardly an advertisement for the approach, and accounting for lost tax revenues due to lower GDP would yield a less impressive fiscal outcome.

Another possibility is that the Europeans concluded that an FTT's political advantages outweigh its economic flaws. After all, there 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.

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 realises 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 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 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.
The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2011

(This story was published in Businessworld Issue Dated 31-10-2011)