An EU financial transaction tax would be folly

You’d think that after a decade of creating one of the world’s biggest financial powder keg in living memory, the leaders of the EU would have a little humility about their plans to tax financial markets. Alas, not. Today’s outline of the financial transaction tax proposal by Jose Manuel Barroso confirms that they plan to throw more gunpowder onto the keg. We published a very good paper on the idea of the Tobin tax recently. A financial transaction tax, like a Tobin tax, would not raise any significant revenue and, crucially, would probably make markets more volatile.

First, a clarification: despite many reports to the contrary, this is not a Tobin tax in the true sense. A Tobin tax is a small tax on spot trades of foreign exchange – intended by James Tobin to reduce volatility in currency markets. But it is similar: the financial transaction tax would apply to stock, bond and derivatives exchanges. The impact will be less profound than a true Tobin tax would be, but most of the same principles apply.

Will it raise money? Probably not: the projections for revenues are based on market volume (ie, the total number of exchanges made) which would probably fall considerably. When Brazil tried a financial transaction tax (now abandoned) it didn’t raise much. Tobin himself rejected the idea that a Tobin tax would raise any money and explicitly distanced himself from groups that did.

I am constantly baffled by the failure of politicians to understand that trading funds can and will move country if the financial incentives are there. How many times have Europe’s leaders lamented cheaper competition from the Far East driving jobs out of the EU? Yet when those jobs are (far more lucrative) financial ones, they seem to think that no similar principle applies. It’s crazy for the EU to claim that it can raise €57 bn per annum without impacting the sector. (Mind you, the British government might be tempted to favour a Eurozone-only tax, as it would probably drive quite a few funds to the City of London.)

More importantly, transaction taxes actually increase the volatility they’re designed to reduce. Tim Harford once gave a good analogy for this. Imagine if you were charged for using an ATM – rather than taking out £20 or £50 whenever you needed it, you might save up your withdrawals until you absolutely needed to, and then take quite a lot of money in one big go. Irregular, large withdrawals would increase the fluctuations in your cash reserves (and the ATM’s) and increase volatility.

Markets exist to factor information into prices. Taxes on exchanges act as a blindfold on them, reducing the number of exchanges that can take place at the margin. If a trade is taxed, it makes some trades with a low expected yield unviable. Traders wait to make their trades – that means fewer and bigger trades. The impact of this tax won’t be as bad as a Tobin tax would be, but it’s a bad step nonetheless. But I’m sure the leaders proposing it know that. Their agenda is a political one: to buy enough time and political capital by appearing “tough” on markets for them to pass more EU bank bailouts.