Lecture VIII - Derivatives Study Center at the Financial Policy Forum

Lecture VIII
• Questions from last
• Transaction Taxes
Lecture VIII
• Keynes mentions in General Theory that a transactions tax might
reduce unwanted speculation, such as that found in the US stock market
• Tobin’s 1974 article
• Context: new exchange rate system changed the effectiveness of
macroeconomic policy tools
• Application to development debate: tool for stability?
Lecture VIII
What is it?
• Small tax applied to foreign exchange transactions, and possibly other
financial transactions
• Given the enormous volume in foreign exchange transactions, the small
tax would raise substantial amounts of new funds that could finance
further development. Sometimes thought of as a source of funds for
poverty and hunger elimination.
• Thus functions like a ‘sin’ tax and funds virtuous activities
• Transaction tax would not affect trade or long-term investment
• TT would not otherwise have negative impact on efficiency
• TT has a good pedigree (Keynes and Tobin)
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Arguments FOR -• Instability caused by speculation, TT would tax speculation, and the
resulting reduction in speculation would increase stability (decrease
• Tax would raise revenue needed to augment financing for development
• Transaction tax would not affect trade or long-term investment
• TT would not otherwise have negative impact on efficiency
• TT has a good pedigree (Keynes and Tobin)
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Arguments AGAINST -• Tax would primarily affect liquidity and not speculation. Liquidity is good
for market stability, not bad. Thus should not tax it. Consequent would be
to make markets less stable, not more.
• Better way to tax speculation would be a capital gains tax. Besides it is
not clear that speculation, per se, is the cause of stability. Even if it is one
cause, it is not the only source of stability and so reducing it would at best
make an improvement but not necessarily a cure.
• The amount of tax raised might be very small.
- Efforts would be made to evade it.
- Reduced trading volume would reduce revenue raised
- World tax revenue is huge and amount going to development is
small, so why do you need new tax revenue to increase funds for
- Developed countries would pay most the tax – why would they give
it to development if they don’t already?
• Implementation would require worldwide cooperation as location of
trading is flexible, derivatives could be used as a substitute, and
cooperation would be difficult as it will hit some countries more than
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Variation: Spahn proposal -• Base tax rate would be very small, perhaps even zero. However a
significant change in the exchange rate would automatically trigger (i.e.
trip wire) a sharp increase in the rate. The higher rate would slow down
international capital mobility and serve to stabilize the value of the
developing country currency when it is hit by volatility.
• Would not impair efficiency or liquidity in most instances because the
base tax rate would be very low.
• Higher tax rate would ‘throw sand in the gears’ at the right time.
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Problems with Spahn variation -• Traders and investors would anticipate trigger and trade ahead of point
of tax hike. This would likely destabilize the exchange rate as it got near
to the trigger level.
• Trip-wire might function as crisis accelerators if the trigger point were
known to market participants.
Lecture VIII
The Magnitude of the Tax Matters
Both the risk shifting and price discovery functions of derivatives market rely heavily on the
low cost of market trading to produce a liquid market with efficient prices. Factors that raise
trading costs, such as taxes on transactions, can hamper the volume of trading and in turn
the liquidity in the market.
Of course there are other costs besides taxation, and also there are rates of taxation that
are so small per transaction that they do not appear to significantly hamper liquidity. As an
example, all futures and options transactions on US exchanges are assessed a $0.17 fee
that funds the SRO – the National Futures Association. This assessment is $0.02 per trade
of a futures or option for trades executed by brokers for their customers. Trades between
exchange members are exempt (and hence the key suppliers of liquidity to the markets are
not subject to even the tiny tax.) Similarly, the US securities market SRO assesses a
transactions fee of $0.0001 per security traded – again a small rate that would be amount to
only one penny per round lot trade by retail investors. The US Securities and Exchange
Commission also assesses a Section 31 fee per transaction of $0.0021 per security futures
trade and 0.00153% of value (or $15.30 per $1 million).[1]
Compare the tax to old NYSE limit on price movements, i.e. the tick size, to $0.125. This created a minimum bid-ask
spread that amounted to 0.003125% on a round lot trade at $40 per share.
Lecture VIII
The above examples are important because they have long applied to markets
that have long been considered highly liquid. The implication is that the impact of
transactions taxes depends very much on the tax rate. Very low rate appear to
have negligible impact, however there is a point where transaction volume will fall
or migrate at a significant rate.[1] The literature focuses on case studies of markets
in which transactions taxes or similar costs, such as the deregulation of securities
broker commissions in the US, were changed significantly. There is not a clear
point estimate of what is too high or low enough, or even the elasticity of trading
volume with respect to taxation. However there are numerous examples of “low
enough” and “too high.”
Below are some undisputed examples where transactions taxes are significantly
affecting derivatives markets. The impact may not be entirely negative however.
Even though the tax provisions tend to discourage the use of derivatives markets,
they are likely to serve to promote the movement of trading activity onto
derivatives exchanges where there is a lower incidence of such tax liabilities.
See Dodd (2005) for a summary of this literature which includes a study by Andrei Kirilenko (2005) in
Dodd, et al (editors), Debating the Tobin Tax.
Lecture VIII
Brazil. Brazil has a debit or bank account transaction tax that is similar to
that in Colombia.
Few foreign exchange derivatives in Brazil are structured as foreign
exchange swaps. This is due to the tax and legal benefits of structuring
derivatives as “cash settled” and thus avoiding the cost and inconvenience of
conducting foreign currency transactions in the settlement of the derivatives.
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Colombia. Colombia’s VAT on foreign exchange transactions and relative derivatives
transactions and other derivatives transactions. The taxation of derivatives transactions
through debit taxes, value added taxes and with-holding taxes raises the cost of hedging,
market making as well as speculation.
In Colombia, there are three taxes that apply directly to derivatives transactions, and they
shape incentives for derivatives trading in various ways:
The Value Add Tax (VAT) applies derivatives transactions in asymmetric ways. In the spot
market, the tax is calculated by 16 percent (the tax rate) applied to the amount of
depreciation measured by the trade price less the previous day’s average exchange rate
for that specific dealer.[1] The VAT is not applied to transactions that are priced as an
appreciation from the previous day’s average rate.[2] In the forward market it is the
amount of depreciation in the spot price less the forward discount points. This taxation of
delivered forwards at 16 percent further biases trading in favor of NDF, which are taxed at
5 percent. In the case of options, the VAT is applied to the premium, and for crosscurrency swaps the 16 percent rate applies to each foreign currency payment in the
contract. Banks generally face many offsetting VAT payments and deductions, and it is the
final end-users who pay the majority of the tax.
As a result, the effective VAT varies from foreign exchange dealer to dealer and customers often “shop” for the lowest
tax rate and dealers must compete in this environment. In turn the dealers quote spot and forward prices on a tax
inclusive basis, and this gives rise to a greater dispersion of observed market prices.
The VAT acts in some ways like a capital gains tax.
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• The with-holding tax applies only to the profits (i.e. capital gains) from trading. While
both profits and losses go into calculating ultimate tax liability, the taxes on gains are
withheld. Thus the tax liability on the gross amount of gains is withheld, and the
consequence is that the time-value on these tax payments less ultimate offsetting trading
losses is lost to non-tax exempt market participants.
• Financial payments in Colombia are subject to a debit or transactions tax (equivalent to
0.4 percent and known as “cuatro per mille”). Trading in equity shares and corporate
bonds are exempt from the tax. Banks acting as foreign exchange dealers are exempt
from paying the tax on foreign exchange transactions. Pension funds are also exempt
from the tax. This creates an uneven playing field in the foreign exchange derivatives
market. It also creates a tax bias in favor of NDF in comparison to delivered forwards.
Non-financial corporations that hedge by rolling-over short-term forwards face significant
tax costs from the accumulated effect of these transactions. In contrast, pension funds
are exempt from VAT, with-holding and transactions taxes, although the pension fund
administrator is subject to with-holding taxes when settling foreign exchange forward
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