Thursday, October 14, 2010

European Commission Gives Policymakers Choices on Financial Sector Taxes

The European Commission has set forth the choices for policymakers considering taxes on the financial sector. In a report to the European Parliament, the Commission settled on two main types of tax regimes: one for financial transactions and one for financial activities. The G-20 is exploring financial sector taxes. The European Council stated, with regard to the recent G-20 Toronto Summit, that the EU should lead efforts to set a global approach for introducing systems for levies and taxes on financial institutions with a view to maintaining a world-wide level playing field and will strongly defend this position with its G-20 partners. The introduction of a global financial transaction tax should be explored and developed further in that context.

A financial transaction tax is a tax applied to financial transactions, usually at a very low rate. Financial transaction is usually defined to mean any exchange of financial instrument between two or more parties. There are possible scopes for such a tax. A financial transaction tax could narrowly apply only to stocks and bonds or could be broadly extended to all financial instruments, including derivatives and structured instruments.

A financial activities tax is a tax on profit and remuneration which applies to all activities of a financial sector company. It can tax all profit and wages or can specifically target economic rents and profits gained through riskier activities. In contrast to a financial transactions tax, where each actor on the financial market is taxed based on its transactions, the financial activities tax targets financial firms.

Currently, noted the Commission, the financial sector enjoys a privileged position in the EU when it comes to taxation since financial services are generally exempt from VAT due to difficulties in measuring the taxable base. A number of studies suggest that this leads to the under-taxation of financial services. Thus, there is the issue of the financial sector making a fair contribution to public finances.

Commission staff recommend that a financial transaction tax be applied to all financial transactions, in particular those carried out on organized markets such as the trade of equity, bonds, derivatives, and currencies. The tax would be levied at a relatively low statutory rate and would apply each time the underlying asset was traded. The tax collection or the legal tax incidence should be, as far as possible, via the trading system which executes the transfer.
For stocks and bonds the value of the transaction would constitute the tax base. For example, if an investor buys 20 shares of a corporation worth EUR 100 per share the tax base would be EUR 2,000. In this sense, it is easy to define tax bases for transactions where the asset price is determined by the market at the time when the transaction is executed.

For derivatives, the determination of the transaction value is more complex. In principle, one could argue that the value of the notional or underlying value could be the tax base. Given the sometimes high leverage of certain derivatives this would have two effects. On the one hand, taxing the notional value creates a very large tax base. On the other hand, the tax payment is large compared to the actual price paid for the contract. While this could reduce leverage taken by means of these contracts, noted EC staff, it would also increases the costs for companies when hedging risk. Also, taxing the notional might lead to double taxation in the case where the underlying is traded and taxed at the spot market if for example an option is executed. Instead of taxing the notional, an alternative way of taxing derivatives could be to tax the actual price only.

Aside from its revenue raising potential, a financial transactions tax could reduce harmful and speculative short-term and high speed trading and thereby link a trade more closely to the underlying fundamental economic market conditions and make financial markets less volatile.

The Commission cautioned that the possibility of circumvention of the tax will increase with the complexity of the operation. An implementation of a financial transactions tax would therefore also require a mechanism that deals with new financial products which might be created in the future. One option would be to automatically add new financial instruments to the tax base in each country or to negotiate their taxation at the EU-level. The risk of tax avoidance exists also in geographical terms as some transactions might move to jurisdictions which do not apply the tax.

Another option for policymakers is a risk-taxing financial activities tax that would tax excess return due to unduly risky activities. Such a tax would directly target the harmful effects of excessive risk-taking. This would be done by applying a relatively high tax rate to discourage risk on returns above a defined level. Since the tax could not distinguish between high returns due to unduly risky behavior or due to skills and efforts, any threshold would be somewhat arbitrary.

In order to obviate the differences in treatment between financial institutions and quasi-financial institutions, reasoned the Commission, the financial activities tax should cover as large as possible a range of financial institutions, including banks, credit card companies, insurance companies, stock brokerages, and investment funds.

At this stage, there is not yet a consensus on an internationally coordinated financial transaction or activities tax at the G-20 level, partly reflecting the differential impact of the financial crisis across its members. The question therefore arises whether the unilateral introduction in the European Union of some of the instruments that have been subject of debate would be feasible and reasonable.

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