A Tax That May Change the Trading Game

http://www.nytimes.com/2013/02/22/business/a-tax-that-could-change-the-trading-game.html

Version 0 of 1.

To the dismay of the United States government — not to mention Wall Street — much of Europe seems poised to begin taxing financial trading as soon as next year.

The idea is hardly new, but until now financial markets and institutions have been able to ward off any such tax in most major markets. The financiers claimed a tax would hurt economic growth and raise the cost of capital for companies. They said it would drive trading to other countries, leaving the country that adopted it with less revenue and fewer jobs.

But those arguments have not proved persuasive in Europe, which thinks it has found a way to keep institutions from avoiding the tax.

If Europe proves to be correct, it could turn out to be a seminal moment in the relation of governments to large financial institutions.

The tax would be tiny for investors who buy and hold, but could prove to be significant for traders who place millions of orders a day.

Under the proposal, a trade of shares worth 10,000 euros would face a tax of one-tenth of 1 percent, or 10 euros. A trade of a derivative would face a tax of one-hundredth of 1 percent. But that tax would be applied to the notional value, which can be very large relative to the cost of the derivative. So a credit-default swap on 1 million euros of debt would have a tax of 100 euros, or about 0.4 percent of the annual premium on such a swap.

I’ll get to how Europe thinks it can prevent widespread evasion in a minute. But for now, assume the Europeans could accomplish that. And assume, as European officials say they hope will happen, that the tax spreads to other major markets, something Europe is trying to encourage by offering to share the tax revenue with other countries that impose a similar tax.

What would happen?

It would not destroy markets that have good reason to exist — that is, markets that serve actual investors. The tax would be far smaller than the fixed commissions that American investors once took for granted, and even less than the costs implicit in the fact that until decimalization arrived in 2001, that most stocks could move only in increments of one-eighth of a dollar, or 12.5 cents. Markets, and the American economy, managed to prosper.

But there would nevertheless be significant changes — changes that might be for the better in some ways. High-frequency trading, which was encouraged by allowing prices to move in increments of a penny or less, and by technological advances, would be discouraged. So too would be some of the strategies used by hedge funds that involve trades expected to yield very narrow — but presumably very safe — profits. To make such trades worth doing, funds borrow a lot of money and make the trades using very little equity. That is a strategy that is guaranteed to work — or to blow up disastrously if markets do not act as expected. Discouraging it might be a good thing.

One objective, says Algirdas Semeta, the European Union commissioner in charge of tax policy, “is to reorient the financial system back to financing the real economy.”

But can Europe pull it off? Will trading simply migrate to other jurisdictions, such as the United States and Britain, which want nothing to do with the tax? Europeans seem confident. The tax would be owed no matter where the trade took place, as long as a European security or European institution was involved. The law has been written so broadly that if a French bank bought shares in an American company on the New York Stock Exchange, the tax would be owed.

Manfred Bergmann, the European Commission director for indirect taxation and tax administration and a primary designer of the tax plan, calls it a “Triple A approach — all markets, all actors and all products.”

To get out of the tax, a financial institution would have to do more than simply move its headquarters out of the 11 countries that now plan to impose the tax. It would also have to forgo serving clients in any of those countries and trading in securities or derivatives from any of the countries. Officials are confident that no major institution will be willing to forsake such large markets as France, Germany, Italy and Spain.

The other countries that have at least preliminarily agreed to impose the tax are Belgium, Austria, Greece, Portugal, Slovakia, Slovenia and Estonia.

The scope of the tax is very broad. The proposal has exceptions for currency trading and the physical trading of commodities, but not for derivatives like currency or commodity futures contracts. When a company sold newly issued securities to investors, that transaction would not be taxed, but subsequent market trades would be. Over-the-counter trades would be subject to tax just as would transactions on a stock exchange, as long as a financial institution — a term that is also defined very broadly — was involved. You could sell your shares in Daimler to a friend without paying tax, but not if you got a broker involved.

There is every chance that markets from other countries will not be very cooperative, meaning that to learn if a German bank traded in New York the authorities might have to rely on the bank to report it to them. But then there would be the risk that the tax authorities would learn of it otherwise, perhaps through an audit or from a report by an Italian bank that happened to be on the other side of that trade.

Mr. Bergmann, himself an economist, compared that to “the prisoners’ dilemma,” a classic concept in economics in which two people arrested for a crime would do best if neither confessed, but either would do very badly if he did not confess while the other did. If the authorities did find out, it would be tax fraud under the proposed law.

The tax would be split, in normal circumstances, between the countries whose institutions were involved. In that German trade with an Italian institution, the two countries would share. But if one of the countries had no such tax, all the money would go to the other government.

Some in Europe hope that the lure of that cash might eventually tempt Americans. Europe thinks it can bring in 31 billion euros — about $41 billion at current exchange rates — from the tax. The United States presumably could collect more if it adopted a similar tax, including some of the money that will now go to European countries.

Legislation such as this probably would have gone nowhere before the financial crisis. The fact this now seems to be on the verge of enactment, perhaps to go into effect as soon as next year, reflects the widespread scorn for, and anger at, banks. Allocating capital is a major — perhaps the most important — job of a financial system, and the banks failed spectacularly at that. Money went to mortgage loans for properties that never should have been built and that were “sold” to people who could not afford them.

Now the European Commission says it is time to ensure that “financial institutions make a fair and substantial contribution to covering the costs of the crisis.” A secondary benefit is said to be “creating appropriate disincentives for transactions that do not enhance the efficiency of financial markets, thereby complementing regulatory measures to avoid future crises.”

Will it work? It appears that Europe is going to find out. Perhaps it will turn out that the dire warnings of disaster that have come from banks, who say such a tax will make capital more expensive for companies that need it and damage already stumbling economies, will prove to be no more accurate than the financial models those same banks used to justify the lending orgy that went so spectacularly wrong.

<NYT_AUTHOR_ID> <p>Floyd Norris comments on finance and the economy at nytimes.com/economix.