Not so fast

By Buttonwood

THE European Union is still talking about a financial transactions tax. Now I'm not in favour of it since it would simply drive a lot of business offshore (and it seems, at heart, an intrinsically anti-British move since the UK has the largest financial sector).

But the consultancy Oliver Wyman has produced a report on the issue and its arguments cause a certain degree of reflection - although not in the way that the authors intended. The report says that the tax will

directly increase transaction cost for all transactions by 3-7 times and by up to 18 times for the most liquid part of the market

adding that

Prior studies have shown that as much as 90% of the additional tax burden on financial institutions is generally passed on to end users. Non-bank financial institutions such as pension funds, insurers and asset managers will be particularly hit

It is a fair point that hedge funds can move to avoid the tax but pension funds and insurance companies can't. But Wyman adds a bit that sticks in the craw somewhat. The levy will

inefficiently tax the economy, as raising €1 of tax will likely cost the economy more than €1 given the indirect costs associated with reduced volume and more fragmented liquidity.

What bothers me about all this is that it seems to consider the financial transactions tax in isolation. Many EU countries are in deficit; the alternative to a financial transactions tax might be taxes on income (reducing incentives to work harder), taxes on sales (distorting spending decisions and bearing more heavily on the poor), taxes on business (which will also get passed through to consumers) and so on. One should look at the tax from the point of the view of the beneficiary of the pension fund; they may prefer to see a tax on transactions rather than a rise in VAT. A test of the "economic efficiency" of a transactions tax needs to be a bit broader.

A second issue is that much evidence shows that active managers underperform the indices; the trading costs that those managers incur are passed on to clients. So if a transactions tax prompts fund managers to trade less, or prompts clients to switch to lower cost index funds, investors may not suffer that much.

A third issue is that liquidity is a means to an end, not an end in itself. The purpose of the stock market is to allow companies to raise money so they can invest in new plant etc, and for savers to be able to allocate capital efficiently (i.e. to the companies with the best prospects). It is not clear that trading every millisecond serves that purpose. The function of the foreign exchange market is to make it easier for companies to trade and for capital to flow to the best international destinations; again it is not clear that the average currency holding period of 31 seconds (according to Andrew Lapthorne of SocGen) serves that purpose.

Now all of the above objections are trumped by the territoriality issue; the financial transactions tax should be simply renamed the Let's give a present to Wall Street and Singapore levy. But if we could devise a global tax system, it is not clear that financial transactions should enjoy their current privileged position.