Lecture VIII • Questions from last lecture • Transaction Taxes Lecture VIII HISTORY • 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) Lecture VIII Arguments FOR -• Instability caused by speculation, TT would tax speculation, and the resulting reduction in speculation would increase stability (decrease instability) • 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) Lecture VIII 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 development? - 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 others. Lecture VIII 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. Lecture VIII 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).  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. 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. Lecture VIII 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. The VAT is not applied to transactions that are priced as an appreciation from the previous day’s average rate. 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. Lecture VIII • 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 transactions.