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The dubious logic of a tax on the stock market

Opponents of financial transaction taxes often argue that these proposed levies are really just massive tax grabs dressed up as weapons to protect the little guys in the financial markets from rampant, destructive speculation.

Maybe that's not fair. FTTs may be lousy as tax grabs, too.

In the quarterly Bank of Canada Review, released this week, the central bank published a new paper summarizing research on the impacts of FTTs – levies imposed on financial activities, most commonly on each trade in the stock, bond, commodity or currency market.

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The great John Maynard Keynes first proposed such taxes in the 1930s as a way to discourage speculators from fuelling stock-market volatility with opportunistic, market-distorting trading.

Lately, the European Union has revived the idea of imposing FTTs on stocks, bonds and derivatives, as both a source of much-needed government revenues and a means to discourage aggressive short-term speculation. The International Monetary Fund has also looked into FTTs as a means to create defence funds – generated by the dealings of the financial industry itself – that could be used toward staving off future financial-industry meltdowns.

The new paper, written by Bank of Canada senior economist Anna Pomeranets, concludes that there is "little empirical evidence" to show FTTs reduce market volatility. In fact, "numerous studies" suggest such taxes actually increase volatility, as the heightened trading costs result in reduced trading volume.

This assessment isn't particularly new; indeed, Ms. Pomeranets and Rutgers University professor Daniel Weaver wrote a working paper published by the Bank of Canada (and discussed in this column) about this time last year that reached the same conclusions, based on their study of various New York State transaction tax regimes between 1932 and 1981.

Separately, the IMF published a working paper last year saying much the same thing, although the paper still asserted that FTTs offered the potential for substantial tax revenues even at a relatively unimposing tax rate. Indeed, the European Commission has suggested that an EU-wide FTT could generate €57-billion ($73-billion) a year.

But in her new paper, Ms. Pomeranets casts doubt about whether the tax-revenue upside is all it's cracked up to be. The straight arithmetic may suggest big numbers, but the realities of the markets have a way of shrinking them. For one thing, the big high-speed speculative investors would likely go venue-shopping to skirt any FTT that a single jurisdiction imposed.

A study of Sweden's FTT on equity trading in the 1980s (highlighted in Ms. Pomeranets' latest paper) found that 60 per cent of the trading volume of the 11 most actively traded stocks on the Swedish exchange migrated to the London market after the tax was imposed, taking a huge bite out of the anticipated tax revenue. Both volumes and share prices for these Swedish issues declined. The resulting declines in capital gains taxes essentially offset the revenues the Swedish government generated from the FTT.

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The way around this would be a global, uniform transaction tax. But as Ms. Pomeranets notes, many countries oppose the idea; the likelihood that every country in the world would agree is little more than a pipe dream. Any jurisdiction unilaterally imposing an FTT would more than likely drive substantial amounts of business out of the country.

Even if country-jumping could somehow be discouraged, the report suggests there's a very real likelihood that the financial community would simply innovate its way around the tax. A whole new class of synthetic derivatives products could be created that would avoid actually trading the underlying securities. With billions of dollars at stake, it's easy to imagine such products thriving and rapidly multiplying – and history suggests regulators would have a hard time keeping pace with them.

If the benefit of all this was smoother, safer, less volatile financial markets, that would be one thing. But when the only real gain – tax revenues – appears questionable, FTTs look like more trouble than they're worth.

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