Tuesday, December 13, 2011

CBO Examines Impact of Legislation Imposing Financial Transactions Tax on Derivatives and Securities

Legislation imposing a tax on most purchases of securities and transactions involving derivatives would have both negative and positive effects on the cost of financing new investments, said the Congressional Budget Office in a letter to Senator Orrin Hatch (R-UT). On one hand, it would raise the costs of financing investments to the extent that it made transactions more expensive, financial markets less liquid, and management of financial risk more costly, said CBO. On the other hand, the financial transactions tax would increase federal revenues and decrease federal budget deficits, which would tend to boost national saving and reduce interest rates, thus lowering the cost of financing investments. In the short term, however, the net result of those contradictory effects would most likely be an increase in financing costs, because the economy is weak, interest rates are already extraordinarily low, and the introduction of the tax might not appreciably change investors’ expectations about future deficits.

The Wall Street Trading and Speculators Tax Act, H.R. 3313 and S. 1787, would impose a tax of 0.03 percent on the value of a security for a transaction involving a stock, bond, or other debt obligation. For a transaction involving a derivative, the tax would be 0.03 percent of any payment made under the terms of the derivative contract, including the price paid for the contract when it was written, any periodic payments, and any amount paid when the contract expired. The tax would not apply to the initial issuance of stock or debt securities, to trading in debt instruments that have fixed maturities of no more than 100 days, or to currency transactions, except that transactions involving currency derivatives would be subject to the tax. The tax would be imposed on trading within the United States and on transactions outside the country if any party to the transaction is a US company, partnership or individual.

The tax would raise the cost of financial transactions, flatly declared CBO. Securities that are traded frequently, such as Treasury securities, would be more affected than securities that are traded less frequently. The tax would also decrease the volume of transactions and would make unprofitable some types of trading activity, such as derivatives transactions to manage risk. In cases where the tax was high relative to current transaction costs for a security or derivative, the volume of trading would drop more than in cases where the tax was low relative to current transaction costs. Transaction costs tend to be much lower for institutional investors, including pension funds and mutual funds, than for individual investors, whose trades are smaller and less frequent.

Traders would have incentives to avoid the tax either by trading offshore or by creating new financial instruments that were not subject to the tax. Because of economies of scale in trading markets, as foreign holders of U.S. securities moved their transactions abroad, more of the market could go with them, which could diminish the importance of the United States as a major global financial market. That effect would be mitigated if other financial centers introduced their own transaction taxes.

In the view of CBO, imposing a transaction tax would probably have a large impact on the frequency of trading in Treasury securities, especially for recent issues, which are traded the most often and have the lowest transaction costs. With about 250 trading days in a year, a Treasury security is traded more than 10 times a year, on average. Further, 0.03 percent transaction tax would be large relative to both the current cost of trading Treasury securities and their yields.

Several factors, however, might reduce the tax’s impact on the liquidity of the market for Treasury securities. Despite the large percentage increase in trading costs, Treasury securities would remain among the cheapest securities to trade that were subject to the tax. Further, Treasury securities would retain several unique characteristics, such as their value in repurchase agreements and their favored tax and regulatory treatment. Repurchase agreements are effectively short-term loans sometimes secured by a Treasury security as collateral.

Such agreements are a means for financial institutions to lend to one another with minimal counterparty risk. Repurchase agreements also enable financial institutions to temporarily transfer ownership of the securities that serve as collateral. Those agreements, which are generally treated as secured financing for tax purposes, would most likely be exempt from the transaction tax.

Similarly, the large share of Treasury securities that are held offshore by foreign entities would be exempt from the tax if they were sold to other foreign entities. In addition, the roughly 5 percent of Treasury securities that have maturities of less than 100 days would also be exempt from the tax.

No comments: