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French President Nicolas Sarkozy, recently claimed that France will try to enact a financial transaction tax on financial institutions before April’s presidential election, intensifying public debate on the issue. At this stage, the issue has failed to gather support from G-20. Within the EU, apart from the vocal opposition from the United Kingdom, it is still unclear how many other EU or even euro area members will support the introduction of such a tax. In principle, the tax will cause the least distortion if it is imposed at a global level, as it will minimize the risk of geographical relocation, especially with respect to the more mobile asset management companies and hedge funds. In this sense, the non-committal stance of the United States and United Kingdom – the two largest financial centres – means that Asia is unlikely to benefit substantially from any geographical relocation triggered by the launch of a Europe-wide financial transaction tax.

The debate over an EU-wide financial transaction tax (FTT) on financial institutions has heated up over the past few months. In the aftermath of the global financial crisis in 2008, the discussion on taxing financial institutions to deter them from taking excessive risks began to gain traction at a global level. At that time, politicians were keen on the idea to make financial institutions contribute towards the cost of the crisis. The EU has taken a particularly active role, with the European Commission issuing a public consultation paper in 2011. At the same time, the EU tried to push for such a tax being introduced at global level under the G-20 framework. However, the G-20 summit in Cannes fell short of endorsing such a proposal (reportedly due to, among others, opposition from the US and UK). The European Commission hopes that the 17 euro area members can agree on such a tax sooner, so that the tax can come into effect in January 2014. More recently, President Sarkozy even suggested that France would seek to enact the FTT before the French presidential election in April if necessary. German Chancellor Merkel agreed with the idea in principle, but acknowledged that it would be important for it to be adopted by all EU members. It is unclear to what extent other countries within the EU, or even the euro area, will support the introduction of a region-wide FTT. Even within France and Germany, vocal opposition from the financial industries remain. Under such circumstances, we do not expect an EU-wide FTT will be enacted before 2014.

Why does the European Union want to introduce such a tax in the first place? There are two main reasons: First, many politicians and commentators argue that the financial sector should make a fair contribution to the cost of the crisis. This is especially important as many financial institutions could not have survived the crisis without significant financial support from governments. Second, it is part of the ongoing process of creating a stronger internal market for financial services. But that is only possible if an FTT is introduced at an EU level, so as to avoid tax evasion and minimize regulatory arbitrage such as geographical relocation. Of course, the distortionary aspect is valid at the global level and that explains the EU’s failed attempt in getting an endorsement from G-20 on such issue.  

How does the EU version of FTT work, if enacted? The tax will apply to financial transactions between all EU financial institutions (including banks, insurance companies, pension funds, investment companies and hedge funds) concerning bonds, shares and derivatives (traded on both organized exchanges and over the counter). To help reduce the risk of relocation, the tax would be based on the principle of tax residence of the financial institution. In other words, as long as one party of the transaction is located in the EU, it would be taxed even if the transaction was carried out outside the EU. The European Commission has proposed the imposition of a minimum tax rate of 0.1% for the trading of bonds and shares and 0.01% for derivative products, and member states have discretion to charge higher rates. The European Commission estimates that at such rates, total tax revenues could reach €57bn per year. However, these estimates are very sensitive to the assumptions on the reduction in trade volumes caused after the introduction of the tax.  

Why are some EU countries so reluctant to agree on such a tax? For a start, many EU countries – Belgium, Cyprus, France, Finland, Greece, Ireland, Italy, Romania, Poland and the UK – already have a form of financial transaction tax in place. These countries will therefore have to modify their national rules to align them with the EU-tax levels. But more importantly, part of the collected tax revenues under the proposed EU-wide FTT plan could go to the EU budget. In that sense, countries with large financial transaction volumes such as the UK will be a big loser in terms of contributions to the EU budget (Figures 1 & 2).

But more importantly, imposing an FTT across Europe unilaterally could encourage financial transactions to move elsewhere, impacting on employment and affecting overall tax revenues. Proponents of this view always cited the experience of Sweden in the 1980s as an example. The Swedish government started to introduce transaction taxes on both equity and fixed-income trades with local brokerage services in 1984. But the scheme was abolished in 1991 due to the migration of trades elsewhere (by 1990, >50% of all Swedish trading had moved to London) and its negative impact on trading volume. Once the taxes were eliminated, trading volumes rebounded sharply in the 1990s. However, critics pointed out that the Swedish experience was mainly a result of a fault in design. Like the UK stamp duty, if the tax is based on the legal transfer of ownership, rather than transaction location, the relocation risk can be minimized. It could also be the case of the current EU-proposal which is based on the principle of tax residence. That said, proponents in the UK argue that it does not prevent more mobile investment companies such as hedge funds to move away from London to other financial centers.

In sum, despite the strong push by France on introducing an EU-wide financial transaction tax, it appears that the chance of such proposal being adopted by all EU countries in the near term is rather remote. In addition, as long as the US and UK are not prepared to introduce such a levy, the beneficial impact to other countries through relocation will be small. That said, all transactions with any euro area financial institutions will be liable to such duty once it is enacted in the euro area.

By Wensheng PENG; Michael CHUI