12 March 2012

Persaud/Griffith-Jones: Why critics are wrong about a financial transactions tax

A negative impact?

Having lost the argument on feasibility, the financial sector and their political friends are now vigorously opposing FTTs with ever more outlandish claims about their negative impact on the wider economy. They have latched on to very preliminary estimates by the European Commission that a 0.1 per cent FTT on equities and bonds could reduce gross domestic product by 1.7 per cent, without waiting for the final analysis.

In its latest iteration, the Commission's model takes into account that the overwhelming majority (85 per cent) of investment comes from retained earnings or bank loans not subject to FTTs. Furthermore, as the Commission's analysis said from the start, the proposed FTTs would only apply to transactions between financial institutions and would not cover companies issuing new shares. Once these factors are taken into account, the Commission's model indicates that the estimated negative effect of FTT on GDP would fall to just 0.1 per cent.

But this is not the complete story. It is necessary to add that the tax would fall most heavily on short-term holders of securities, such as high-frequency traders, hedge funds and bank proprietary trading desks. It would fall least on long-term holders such as pension funds, life-insurance companies and private equity firms. This would likely trigger a shift away from short-term trading in favour of long-term holding that will reduce misalignments in markets and their subsequent abrupt adjustments or crashes.

Crash course

FTTs would therefore somewhat decrease the likelihood of future crises. Indeed, among those countries that were least affected by the crash, countries with FTTs were disproportionately represented. If we conservatively estimate that the probability of crisis would decrease by only 5 per cent as a result of the FTT, which is very low, and we take into account that on average financial crises decrease gross domestic product (GDP) by around 7 per cent, we would have a positive impact of +0.35 per cent of GDP due to smaller likelihood of future crisis. The total net effect of an FTT would be an estimated boost of Europe's GDP by +0.25 per cent, not a reduction. A more detailed version of this analysis can be found in the authors' recent report presented to the European Parliament.

At a time when many European governments face large deficits, in large part as a result of bailing out the financial sector, it seems reasonable to expect the financial sector to adopt measures to help reduce the likelihood of future crises. To us and hundreds of other economists, the evidence is clear that an FTT adopted by all 27 EU states or by the 17 members of the eurozone would help strengthen Europe's finances and reduce the likelihood of crises.

As the FTT is one of the first international taxes, a proportion of its revenues should be earmarked to finance the solutions to some of the world's most difficult international problems, such as poverty and climate change. Therefore, an FTT could help foster somewhat fairer and more sustainable growth in Europe and globally.

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