IS A FINANCIAL TRANSACTIONS TAX?
The Benefits of Taxing Financial Transactions
The Costs of Taxing Financial Transactions
REVENUES FROM AN FTT
Revenues in Theory
Some Empirical Considerations
Revenue Estimates for Canada, Based on the International Experience
Independent Revenue Estimates
FINANCIAL TRANSACTIONS TAXES:
PROS, CONS, DESIGN ISSUES AND REVENUE ESTIMATES
When G-7 leaders met in
Halifax, Nova Scotia in the summer of 1995, many had hoped that the proposed
Tobin Tax (named after Professor James Tobin) would be high on the agenda.
This tax, applied to virtually all spot currency exchange transactions,
was seen by its proponents as a way of curbing excessive currency speculation,
exemplified by the earlier Mexican peso crisis. While the original rationale
for the tax was to curb speculation, the revenue potential of a global
tax base equal to US$1 trillion per day also had an obvious appeal. Proponents
of the tax are disappointed that it was not taken seriously last year
by the major governments and that it is faring no better in 1996.
Another form of transactions
tax is also in the news, however. If international financial transactions
cannot be taxed because international consensus is not forthcoming, why
not tax domestic financial transactions instead? Speculation in bond and
equity markets is considered at best only slightly less distasteful than
currency speculation, and the sheer magnitude of domestic financial transactions
would provide a base so large that even a miniscule tax rate could generate
tens of billions of dollars annually in tax revenues. At least so say
the Canadian proponents(1)
of a Financial Transactions Tax (FTT).
While such taxes are now
being advanced as sources of government revenue, they were promoted after
the stock market crash of 1987 as a way of stabilizing financial markets.
The administrations of Presidents Bush and Clinton discussed such taxes
and a 50-basis-point tax was considered during the 1990 American budget
deliberations. Both Presidents also proposed taxes on futures trading,
ranging from 11 cents to 14 cents per transaction.
The distinct advantage of
an FTT over the Tobin Tax is that it does not require international agreement
to implement. Individual nations can, and do, levy such taxes. Thus there
is a certain amount of international experience to examine, should the
Government of Canada consider implementation.
This paper discusses a range
of issues related to a financial transactions tax. The first part looks
at the more theoretical issues: what the tax is, why it is suggested and
why it is opposed. The next part considers some of the design issues that
should be dealt with if the government considers implementing such a tax.
Finally the paper looks at revenues from FTTs, in theory and in practice,
and attempts to provide some estimates of amounts that could be realized
This paper makes frequent
reference to the international experience with FTTs. The reader may wish
to consult the companion piece BP-419, Financial Transactions Taxes:
The International Experience and the Lessons for Canada.
IS A FINANCIAL TRANSACTIONS TAX?
A Financial Transactions
Tax can be thought of broadly as any tax, fee, duty, etc. imposed by a
government upon the sale, purchase, transfer, or registration, of a financial
instrument it is, for the most part, a turnover tax. It can be
broadly based or it can exempt a variety of instruments, or transactions
by certain types of traders. It can be an ad valorem tax or a specific
tax. It can be levied against transactions by Canadians or it can be levied
against transactions in Canada, or both. And the law can levy the tax
on buyers (as in the United Kingdom), sellers (as in Japan), or both (as
in France). To avoid confusion, the tax rates used here represent the
total tax cost of a "round trip" transaction, i.e., a purchase
and sale. The economic incidence of the tax will, of course, depend upon
As a general rule, FTTs
in other jurisdictions do not tax activities such as bank withdrawals,
cheque writing, or obtaining financing for a car or home. Although some
groups proposing an FTT in Canada do seek to tax such transactions, because
of the size of the potential tax base, to do so would make Canada relatively
unique. Consequently, the discussion here will be restricted to the more
conventional use of the tax.
In Brazil, a temporary tax
of 25 basis points(2) on
bank withdrawals was introduced in 1993, with a variety of special measures
for withdrawals of salary, pension benefits etc.(3)
This tax was, however, intended as a temporary measure in response to
a financial crisis and it was eliminated at the end of 1994.
The ultimate impact of an
FTT on markets will depend upon the characteristics listed above as well
as the financial environment. The consequences in a large economy or a
closed one with little capital mobility will be different from those in
a small, open economy where capital can flow freely across borders. The
net impact on government revenue will also depend upon the environment
in which the tax is implemented as well as upon its design.
The international experience
shows a wide variety of tax designs. Often, transactions outside national
boundaries are not subject to tax; where they are so subject, they pose
considerable enforcement problems. Trading in national government securities,
and the trades of specialized traders (such as market makers or others
providing liquidity to the market) are often not subject to tax or, in
the latter case, may be subject to reduced tax rates. These features can
significantly reduce the tax base upon which the FTT is applied.
The Benefits of Taxing Financial Transactions
The earliest notable proponent
of a tax on financial transactions was John Maynard Keynes, who believed
that investment in real capital and trade, not speculation, should be
the basis for financial transactions. As he put it, "It is usually
agreed that casinos should, in the public interest, be inaccessible and
expensive. And perhaps the same is true of Stock Exchanges."(4)
Thus, to use the now famous phrase of Professor James Tobin, we should
"throw some sand in the gears of financial markets" to slow
down and discourage speculative trading.
Most of the academic proponents
of such a tax hold this view. They believe that financial markets are
complex and costly institutions that are too efficient and that
do little more than reallocate existing wealth. While the gains to society
from such activities are small or negligible, in their view, the potential
gains to individual investors can be great. Consequently, such speculative
activity diverts large amounts of resources and very talented human capital
away from socially beneficial activities. Moreover as the financial sector
grows, the government must devote more resources to policing it, while
fewer resources are available for the financing of real economic production.
Proponents of the tax note that top American business school graduates
seek positions in the financial sector while their Japanese counterparts
go into manufacturing.(5)
Worse still, short-term
trading due to speculative activity might actually weaken the ability
of financial markets to support the real economy. Short-term trading is
believed to increase market volatility. Since excessive volatility increases
risk, thereby raising the cost of capital, firms find it more difficult
to procure the financing needed for real investment. Moreover, such excessive
volatility could be associated with a reduction in the efficiency of capital
markets, resulting in reduced economic welfare. Short-term traders are
seen as "noise" or "fad" traders who base their decisions
on information that has nothing to do with the intrinsic or fundamental
value of financial investments. Because they move with the herd, these
traders cause prices to rise excessively in bull periods and to fall excessively
in bear periods. This causes resources to be misallocated, because investors
face price signals that are misleading indicators of the fundamental value
of certain investments.
All of this is due to trading
based on irrational "animal spirits," rather than on the true
value of investments, their dividends and future earnings prospects. These
characteristics lead to very short-term investments where the commitment
to hold shares is subject to a wide variety of influences, inducing waves
of optimism or pessimism. Raising the cost of such trading should reduce
its incidence, resulting in more efficient markets, less volatility and
lower cost capital.
Conventional wisdom holds
that portfolio managers in North America suffer from myopia, because they
are hired and fired on the basis of quarterly results. This myopia becomes
contagious as firm managers, who are concerned about their stock prices,
must also take a short-term view. An FTT should discourage such behaviour
because it disproportionately taxes short-term traders, who trade more
frequently. If the tax succeeds in driving irrational investors out of
the market, efficiency should be enhanced.
As the idea of an FTT moves
from the academic to the political realm, the market effects become subservient
to another anticipated benefit, namely the fact that a tax would generate
revenues for governments. As the players at the "big casino"
are typically perceived to be large institutions, highly-paid traders,
investment managers, and wealthy individuals, the tax is promoted as not
directly affecting the majority of Canadians and as being very progressive
in its impact.
The Costs of Taxing Financial Transactions
Just as the proponents of
an FTT cite a variety of arguments in its favour, so the opponents of
the tax counter these with their own theoretical and empirical arguments.
In the first place, those
who decry the "wasted" resources associated with financial activity
might be surprised at all the similar activity that could be generated
by a tax. History is full of examples of attempts to avoid taxes, and
financial innovations designed merely to circumvent them, all of which
require ever greater government oversight and expense to counter. Because
of the innovative skills of accountants and lawyers, these side effects
are hard to predict.
Two American examples of
such innovation include the development of money market mutual funds designed
specifically to provide savers with an alternative to interest rate-capped
deposit accounts, and the zero-interest bonds that until 1982 were used
to exploit loopholes in the American income tax code.(6)
While the arguments above
link market volatility to short-term trading, they hinge on the belief
that short-term traders are by nature destabilizing speculators. Some
speculators, however, can stabilize a market and a tax that has a disproportionate
impact on short-term traders would affect these speculators too.
Financial markets are volatile,
since information about the value of securities is costly. Are they too
volatile and has this volatility increased recently? The empirical evidence
does not clearly support that thesis. Transactions costs in the United
States have fallen rapidly due to deregulation of financial services and
enhanced competition. Trading volumes have consequently grown and are
relatively higher in the U.S. than in other countries. Yet there is no
clear evidence that the United States is today a more volatile market
nor that volatility has grown in response to this higher trading volume.(7)
Indeed during the 1987 stock market crash, stock prices fell more in some
countries with FTTs than they did in Canada or the United States, countries
without such taxes (see Figure 1). While it is also true that prices declined
by a lesser amount in some countries with FTTs, such as Germany, Austria,
and Japan, national stock price declines showed no evidence of being affected
by the existence or size of such taxes.(8)
Furthermore, the distributional
impact of an FTT might not be as desirable as expected. It is true that
wealth holdings rise more than proportionately with income. But institutional
investors are becoming increasingly important players in financial markets,
and their clientele is much more broadly representative of Canadian society.
More importantly, however, if the introduction of a tax caused asset prices
to fall, the retired and near retired would suffer a disproportionately
large impact, even though most are not rich. Pension funds, even passively
managed ones, might find it difficult to meet their commitments in such
The unintended side effects
of an FTT would not stop there, however. Such a tax could reduce the efficiency
of capital markets if it created inertia amongst investors. If investors
did not react to new information, the prices of securities would not reflect
true economic value and financial resources would not be allocated efficiently.
This would raise the cost of capital and hence reduce the amount of capital
formation. The long-run consequences would be a reduction in productivity
and hence real wages.
Note: The vertical axis
is the percent change in stock prices for the period one week before the
October 1987 stock crash to two weeks after the crash. The horizontal
line is the average percentage of decline in U.S. stock prices.
Source: C.S. Hakkio, "Should
We Throw Sand in the Gears of Financial Markets?" Federal Reserve
Bank of Kansas City, Economic Review, Second Quarter, 1994.
In the final analysis, the
impact of an FTT on the workings of financial markets can only be settled
empirically, as there are theoretical arguments on both sides. This is
also true of the tax revenue arguments; opponents believe that revenue
estimates are overstated and that in the end the revenue benefit of the
tax does not outweigh the negative side effects.
As with the design of any
tax, some obvious questions come to mind with respect to an FTT. Is there
anything apart from creating revenues that we wish the tax to accomplish?
Whom do we wish to tax? Why? Which transactions do we wish to tax? How
much do we wish to tax them?
An FTT can have very dramatic
implications for financial markets and these might well temper our original
thoughts. For example, should money market instruments (those with a term
to maturity of less than one year and as low as 30 days) be taxed? If
we believe that all financial instruments should be treated equally, then
the answer is yes; otherwise the tax would distort individual choices
about financing instruments.
A 90-day treasury bill must
be rolled over four times per year and, if taxed, would therefore pay
four times the tax paid by a one-year bond held to maturity. One solution
would be to ensure that the initial purchase of a debt security and/or
the redemption of the security upon maturity was free from tax. Another
approach would be to use variable rates for securities with different
maturities. This approach has, however, proven to be fraught with difficulties.
Such solutions should, in general, have only a minor impact on the tax
But even such solutions
might not be sufficient. Money market instruments provide institutional
investors such as mutual funds with a temporary place to keep money until
they decide where to invest it. In this sense, these instruments are like
cash they are not an investment in themselves but only an intermediary
to a longer-term investment. For the Bank of Canada, they are an instrument
whereby monetary policy is conducted. For financial institutions in general
they constitute tools that enable adequate income-earning reserves to
be held in support of investments.
Money market instruments
are favoured for their safety and liquidity. No-one speculates against
them. Taxing transactions in money market securities would merely increase
the cost of government borrowing and reduce the value to markets of this
very useful tool. They have close substitutes in the form of banking products
and, as a result of these factors, many countries with an FTT exempt money
The Swiss did not do so and consequently a money market never really developed
in Switzerland. The companion to this paper (BP-419) cites the case of
Sweden, where a 20% drop in money market trading resulted from a tax of
only one-fifth of one basis point.
On the other hand, if money
market instruments were exempted from an FTT, the potential tax base shown
in Table 2 below (p. 20) would decline by almost two-thirds. If only federal
Treasury Bills were exempted from the tax, the base would fall by about
Many governments do not
tax any government securities and the American proposals in 1990 exempted
all federal bonds. This exemption recognizes that the tax would generally
be fully reflected in borrowing costs. Exempting federal bonds would reduce
the tax base by another 31%.
If the tax exempts federal,
or all government, securities, be they short-term or long-term, an obvious
distortion is created with respect to private sector debt. And if all
debt securities are exempt from tax, they become more attractive to investors
than equity securities. In such a case firms might wind up with higher
debt-to-equity ratios in order to exploit this preference, making the
corporate sector all the more risky.
There are many additional
design issues. Countries with FTTs often exempt primary transactions,
such as the issue of new stock or debt instruments, although there are
some notable exceptions. By taxing these activities, the government would
distort firms choices regarding external and internal financing
of projects and put small, rapidly growing and capital hungry firms at
a disadvantage. Exempting primary transactions has a negligible impact
on the potential tax base, as shown in Table 2.
Many financial transactions
are also intermediary to the ultimate goals of the investor. The purchase
and sale of mutual fund shares is an example taxing such transactions
as well as the transactions of the fund itself would lead to double or
even multiple taxation, which in turn could lead Canadians to invest in
American mutual funds. Other transactions are employed simply to hedge
risks associated with some other transaction this is particularly
true of derivative products. With competitive markets, all the taxes imposed
on these intermediary transactions would be borne by the consumer.
Another problem facing the
design of an FTT concerns the role played by market makers. A market maker
is a broker who holds inventory in a particular stock or stocks and provides
liquidity to the market when other buyers and sellers do not. Such transactions
account for one-fifth of the trading on the New York Stock Exchange and
the precentage is likely to be similar in Canada. These specialists are
even more important players in the trading of futures contracts or trading
in over-the-counter markets such as NASDAQ in New York or the Canadian
Dealing Network in Toronto. Imposing taxes on the trades of intermediaries
and market specialists would likely drive up the cost of market liquidity
by raising their bid-ask spreads.
Would a Canadian FTT attempt
to tax offshore transactions by Canadians? American proposals that such
transactions be taxed pose substantial enforcement difficulties. Appealing
to international co-operation in this regard would not solve the problem
as numerous countries would be happy to become centres for such international
The financial market contains
numerous products that are close substitutes. A government bond is a close
substitute for a high-quality corporate bond. Treasury Bills are close
substitutes for other money market instruments. Bank deposits are substitutes
for money market funds.(10)
Taxing one set of products would encourage investors to seek out non-taxed
substitutes. Investors can also generate similar risk and return characteristics
with investments in equities or in derivative products. It is very difficult
to tax derivatives in a manner that is neutral with respect to other financial
products. Not doing so, however, generates inefficiencies and unfairness
and will erode the tax base.
A small tax generates little
distortion and tax avoidance activity, although the Swedish experience
suggests that in some markets and for some products, even a "low"
tax rate might prove to be excessive. But administration and compliance
costs contain fixed and variable components and a small tax might generate
revenues that were very low in relation to those costs. Given the nature
of the institutions involved in such transactions, the administration
costs for the government might be minor but compliance costs for the private
sector could still be high. The international experience is that the tax
is imposed on buyer or seller, not on the intermediary. Large numbers
of individual records must be kept, both for the benefit of the taxpayer
and for the benefit of the government wishing to audit and enforce the
In general, a broad base
is more neutral in effect than a narrow base, because there are fewer
untaxed alternatives. Some parts of the base are, however, inherently
untaxable or at least very difficult to tax. Attempting to tax these might
just lead to enforcement difficulties and high enforcement costs, high
government administrative costs in general and a host of unforeseen consequences.
It would probably prove
impossible for an FTT not to favour one product over another, no matter
how broadly the tax was applied and how carefully it was designed. For
example, it was noted above that investments in mutual funds could lead
to double or higher taxation. One solution would be merely to exempt from
tax the purchase or sale of mutual fund shares. This, however, could create
new problems. Mutual fund companies offering investors the opportunity
to switch investments amongst a family of funds would be advantaged over
stand-alone firms. A major loophole might be the development of specialized
mutual funds holding only one security or small set of securities.(11)
Investors, including other mutual funds, could then effectively trade
securities by buying and selling mutual fund shares, without paying any
The problem in designing
an FTT is that every financial product, including banking and insurance
products, has a close substitute elsewhere. These substitutes could be
equities, fixed-income securities or derivative products, or some combination
of these. New products, moreover, can develop rapidly, easily and unexpectedly
to mimic the income, risk or ownership characteristics of other products.
The government could find itself in a perpetual race to keep up with financial
innovation so as to ensure that the FTT was neutral in effect and not
a source of innefficiency to the economy.
REVENUES FROM AN FTT
In the final analysis, we
might conclude that an FTT has no great effect, good or bad, on the workings
of financial markets. Even so, there might still be cause for taxing financial
transactions as a way of raising needed government revenues and introducing
some amount of neutrality into a tax system that taxes a wide range of
non-financial transactions and services.
Since Canada has no experience
with an FTT, it will be instructive to look at the international experience
and at academic estimates before trying to establish our own revenue estimates.
First, however, we should look at some of the factors that would go into
any estimate of government revenues.
Revenues in Theory
Revenues from an FTT can
be expressed by the following equation:
REV = t(P+D P)(Q+D Q) + D
OTHREV - D EXPEND
where: REV is federal revenue
from the FTT
t is the
FTT tax rate
P is the
average price of securities subject to tax
Q is the
number of transactions
other federal government revenue
The delta sign (D ) signifies
changes in a particular variable.
If an FTT had no impact
on financial markets and imposed no additional administrative or compliance
costs, the above equation can be expressed simply as:
REV = tPQ.
In such a simple world,
tax revenue would equal the tax rate multiplied by the total value of
transactions, i.e., the quantity of transactions multiplied by the average
price. In this case it would be a simple matter to calculate tax revenue:
we know the volume of transactions quite accurately; multiplying that
volume by the tax rate gives the total tax revenue. In such a simple world,
a one-basis-point tax on the transactions in Table 2 (p. 20) would generate
revenues of $1.06 billion.
It is, however, unrealistic
to suppose that an FTT would have no impact on financial market behaviour.
Consequently, the more complex equation needs to be used. This equation
suggests four possible ways in which a transactions tax might have an
impact on total tax revenues.
The value of transactions
can change for two reasons: an FTT could affect the volume of transactions
as well as the price of securities traded. That the number of transactions
might decline is not surprising; this is seen as one of the virtues of
an FTT. What is not so clear is the magnitude by which transactions would
fall. The average price of securities traded might also change, however.
It might increase but it would be more likely to fall.
Two indirect effects also
cannot be ignored. Other government revenue could change as a result of
an FTT. In particular, if the tax had an impact on the average price of
securities, capital gains or losses would be generated, affecting income
tax revenues. This impact would either add to or subtract from FTT revenues.
As well, other tax revenues could fall if business financing costs rose,
or if the tax added to compliance costs. For example, suppose a firm that
had previously financed its working capital by issuing one-year corporate
paper at a 6% interest rate were to face a 15-basis-point FTT. If it could
find alternative financing from a financial institution at 6.1% per year,
it would do so. Not only would an FTT-taxable transaction be replaced
by a non-taxable one, the higher cost of borrowing would reduce corporate
profits and thus reduce the governments corporate income tax revenue.(12)
In addition, an FTT could
affect the cost of government borrowing this is an important consideration
for Canadian governments, which are already heavily burdened by debt.
All governments, but especially the federal government, rely heavily on
short-term debt instruments to finance their deficits, past, present and
future. A 90-day Treasury Bill is rolled over four times per year, even
if held to maturity. If each rollover cost an investor FTT tax, these
instruments would be less desirable than longer term instruments; thus,
governments would have to pay more for such bills or do their financing
on longer terms. The government today enjoys a substantial interest rate
advantage on 90-day T-Bills; it is likely that an FTT on such transactions
would be reflected entirely in higher borrowing costs to government.
Yet even this understates
the effects on governments and other Canadian borrowers. Canada is a small,
open economy that is, on balance, a net borrower from the rest of the
world. Non-residents lend more to Canadians than we lend to them, and
it is unlikely that Canadians could, through an FTT, force them to take
a lower return on their money. Similarly, Canadians already invest in
the rest of the world, primarily the United States, where no FTT exists;
a domestic FTT would make such investments even more desirable. Consequently,
we would have to accept the world real rate of interest and bear the full
cost of any FTT. Any new government borrowing would bear the full cost
of an FTT and any new private borrowing would do so as well, leading to
lower profits and lower corporate income tax revenues for governments.
There are also administration
costs associated with any tax, especially a new one. These costs are of
both the fixed and variable type so that a low tax rate would probably
exhibit less administrative efficiency than a higher rate. The size and
nature of the tax base will also affect administration costs the
broader the base, the greater these costs will be. It would be relatively
expensive, for example, to administer and try to enforce a tax applied
to Canadians financial transactions abroad.
No Canadian tax can be discussed
without mentioning the federal-provincial aspects. The FTT would be a
federal tax but it would have provincial consequences. On balance it should
cause provincial net revenues to fall. This decline would be due to a
reduction in the provincial tax base caused by lower capital gains, higher
operating costs to business, higher financing costs to business, and the
possibility that the FTT might constitute a business expense. The FTT
would also affect provinces to the extent that it raised their borrowing
Some Empirical Considerations
Average Securities Prices:
Proponents of an FTT argue that, by reducing volatility, the tax would
reduce risk in financial markets and thus increase the price of financial
securities. This would be true only if volatility was actually reduced,
however. If volatility remained the same, or even grew, prices would not
rise. Most of the empirical evidence suggests, on the other hand, that
prices would fall.
Several studies have suggested
a wide range of possible estimates for declines in asset prices. For example,
it has been estimated that a 0.5% broadly-based FTT would reduce prices
of all stocks on the New York Stock Exchange by as little as 1.2% to 7.7%,
or as much as 13%. For very liquid stocks, the price decline could be
as high as 18%. (These price changes are in addition to the normal variation
in prices that occurs in financial markets.)
There are several reasons
for these estimates. Taxing any product that has untaxed substitutes will
inevitably lead to some price decline. And, since the ultimate transactions
costs associated with any security will increase with the imposition of
an FTT, asset prices have to fall in order to maintain a competitive rate
of return; that is, the expected future tax liabilities become capitalized
in the price of the security. The prices of those assets that trade more
frequently will decline more, in order to compensate for the larger total
tax bill. Liquid stocks will suffer a relatively large price decline because
they trade frequently. The evidence from the Swedish FTT is consistent
with this interpretation.(14)
Opinions differ with respect to the impact of the FTT on asset prices,
but there is no difference of opinion as to its impact on trading volume.
Increasing the cost of a financial transaction should reduce its volume,
just as raising the price of any good reduces the quantity demanded. Financial
transactions appear to be particularly sensitive to price. The extent
of this sensitivity depends very much upon the alternatives available
to the investor and upon the pre-tax transactions costs of an FTT. The
biggest impact will likely be on institutional traders; these are not
only the largest traders but their trades also have by far the lowest
It has been estimated that
a 0.5% broadly based tax would reduce American trading volumes by about
8%. Other studies suggest stronger effects. Estimates of the elasticity(15)
of turnover with respect to transactions costs range from a low of -0.26
based on data for 1968, to -1 using Swedish data and -1.7 using English
data.(16) Another study
has concluded that long-term American trends in transactions volumes are
consistent with an elasticity of -2 to -3.(17)
The two variables discussed
above are directly and inversely related. If the turnover of a particular
security is expected to fall dramatically in response to a tax, then the
price of the security will remain relatively stable, as there is little
tax to be capitalized. If on the other hand, turnover is expected to remain
stable, then there will be more tax to be capitalized into the security
so its price will fall to a greater extent.
The literature has little
to offer empirically about the indirect effects of an FTT. The case of
Sweden suggests, however, that the loss of indirect revenues will offset
much of the direct FTT revenues.
Revenue Estimates for Canada, Based on the International Experience
Table 1 presents an international
comparison of direct revenues from FTT-type taxes in the mid 1980s. It
measures revenue against three different bases to give some indication
as to the revenue fertility of these taxes.
The table is of only slight
help in estimating FTT revenues for Canada. Switzerland, with a tax rate
not much different from that of Germany, raised twelve times as much revenue
in relation to the size of the economy. Switzerlands role as a safe
financial haven has resulted at times in an undesirably strong currency
due to large capital inflows. The Swiss system of financial taxes was
at times designed specifically to stem this capital inflow,(18)
and this might well be the effect being picked up. Canada does not suffer
from this problem.
TRANSACTIONS TAXES AND REVENUES
(in basis points)
AS A PERCENTAGE OF:
VALUE OF EQUITY
30 & 15
18 & 55
15 & 30
Source: L.H. Summers and
V.P. Summers, "When Financial Markets Work Too Well: A Cautious Case
For a Securities Tax," Journal of Financial Services Research,
Vol. 3, 1989, p. 275.
Italy, with a relatively
low tax rate, generates an impressive amount of revenue. But its tax revenue
as a proportion of the market value of equity is so out of line with that
of the other countries, and so large, that it appears untenable. The UK
tax, which also brings in an ample amount of revenue, taxes away only
0.01% of the market value of equity, far out of line with other taxes,
like that in Germany, that raise less revenue.
All these contradictions
suggest that the design and implementation of taxes vary substantially,
and in a way that cannot be captured easily in tabular form.
As a rough estimate, one
might obtain possible revenue estimates for Canada in 1996 by extrapolating
from the tax to GNP ratios presented in Table 1. Revenues range from $300
million (Germany), $1.275 billion (Japan), $2.25 billion (United Kingdom),
to a maximum of $3.75 billion (Switzerland).
In 1990, the American Congressional
Budget Office (CBO)(19)
calculated that a broadly based, 50-basis-point FTT on all securities
transactions in the United States and all foreign transactions by American
nationals would raise about US $13.4 billion in fiscal year 1995, equal
to about 0.2% of GDP. This translates roughly into Canadian revenues of
$1.5 billion. For the purposes of the CBO calculation, the only transactions
exempted from tax would be the purchase and sale of U.S. Treasury securities.
The annual take from British
taxes and duties on financial transactions is about £800 million. When
numbers are applied to the American market, they estimate revenue of US$7
billion per year if scaled up by the capitalized value of the American
equity market, or US$11 billion if scaled up by the trading volumes in
the United States.(20)
On the surface these estimates seem easily to confirm the CBO estimates,
since the UK taxes are not applied to fixed income securities. But, as
Froot and Campbell point out, transactions costs in the United States
are the lowest of any in the major financial markets, which explains that
markets high trading volumes. Even a small FTT would have a disproportionately
high cost on total transaction costs and consequently a disproportionately
large impact on trading volumes.
Using the above technique
to extrapolate Canadian revenues from the British data produces relatively
low revenue estimates: $550 million if based upon capitalization and $730
million if based upon trading volumes. In 1995, for example, the value
of trades on the Toronto Stock Exchange was about 5% the value of those
on the New York Stock Exchange. The capitalization of stocks on the TSE
was about 6% that on the NYSE.(21)
The reader should note that
these estimates for Canada are based upon the tax designs used in other
countries. These generally employ high rates of tax on equities and small
or non-existent taxes on debt securities, especially government debt.
Independent Revenue Estimates
The size of the Canadian
"casino" in 1995 was about $10.6 trillion dollars, up from $10.1
trillion the previous year;(22)
these amounts equal the total value of transactions in equities, bonds,
and money market instruments, in both the primary and secondary markets.
In 1995, the corporate sector issued $25.5 billion in new securities,
of which $16 billion was equity and the remainder debt. Canadian governments
issued $59.3 billion in new debt securities.(23)
New debt instruments are issued for new financing as well as to finance
older debt that has matured during the year. Primary market activity accounts
for less than 1% of total activity.
The following table provides
greater detail of those transactions. As it points out, equity transactions
represent a very small part of total financial transactions, the vast
majority of which are bonds and money market securities (i.e., fixed income
securities with terms of less than one year). And about three-quarters
of all trading is in Government of Canada securities. The sums are large
and growing at a rapid rate. Thus this appears to be a desirable tax base.
The magnitude of this base
can be sensed from the fact that 1% of $10.6 trillion is $106 billion.
One-tenth of 1% (i.e., 10 basis points) of $10.6 trillion is $10.6 billion
and one-one hundredth of 1% (i.e., one basis point) is equal to $1.06
billion. As is explained elsewhere in this paper, one should not view
these as estimates of tax revenue it would be very misleading to
suggest that a one-basis-point tax would raise $1 billion in tax
revenue per year. The numbers are, however, helpful in giving a sense
of the size of the potential tax base.
According to some, however,
even this large number represents a small fraction of the potential tax
base. Canadian proponents of the FTT cite total transactions of close
to $53 trillion per year, which, in addition to the transactions listed
in the table, include the exchange of cheques, the granting of loans and
mortgages, deposits into and withdrawals from banks, etc.(24)
According to this figure, the numbers in Table 2 represent only about
20% of the potential tax base.
To put the $53 trillion
in better context, the Canadian Payments Association cleared $23 trillion
in paper-based and electronic transactions in 1995. This does not include
transactions drawn upon and deposited within the same institution, a number
which, given the large size of our domestic banks, is also very large.
The following provides an
estimate of the potential revenue that the federal government might enjoy
from a tax on financial transactions. The calculations are based upon
a 10-basis-point tax applied to transactions in equities and a one-basis-point
tax on fixed income securities.
FINANCIAL TRANSACTIONS IN CANADA
(in billion dollars)
Numbers do not necessarily
add up due to rounding and the exclusion of minor categories.
Source: Investment Dealers
Association of Canada, Capital Market Statistics, March 1996.
When considering the implementation
of an FTT in Canada, it is important to recognize that the three broad
categories in Table 2 represent three different financial markets that
would be affected by the tax in very different ways. The equity market
represents a base of about $250 billion. Round trip trading costs for
Canadian institutional investors are in the range of 80 to 100 basis points.
A 10-basis-point tax represents a 10% to 12.5% increase in transactions
costs. As the Canadian capital market is already very much integrated
with that of the United States, trading volumes in Canada should be quite
responsive to the tax. Assuming a turnover elasticity of -2, Canadian
trading volumes should fall by 20% to 25%. While the elasticity figure
used here is in the upper range of estimates presented in this paper,
it is likely to be appropriate, given the pull of the American financial
markets in Canada.
Trading Canadian shares
on American exchanges does have some disadvantages: it is primarily Canadian
investors, analysts and traders who are interested in Canadian shares.
Thus liquidity and knowledge are more prevalent in Canada than in the
U.S., making the market for Canadian securities most efficient here. This
efficiency tends to ensure that prices are close to their true value.
In the United States, Canadian securities represent only a minor part
of the market and hence the services associated with trading them could
Despite these difficulties,
almost one-half of the value of trades of Canadian-based, interlisted
shares takes place in the United States, and Canadian exchanges are very
concerned about this loss of market share. Anything that enhanced the
relative position of American exchanges would just make life more difficult
for Canadian investors as it would encourage trading away from the natural
marketplace. Canadian institutional investors already attempt to trade
as much as possible in the United States to take advantage of lower trading
costs. A large FTT would increase this discrepancy between American and
At $3.6 trillion per year,
the bond market in Canada is 13 times larger than the equity market. Trading
costs are much lower than in equity markets, five to ten basis points,
so a one-basis-point tax is in fact a very high rate of tax. In Sweden,
a three-basis-point tax on bonds caused trading to drop by 85%. In Japan,
a disproportionate share of Japanese bond offerings and trading takes
place in Europe, not Japan. This feature has been attributed to the Japanese
system of taxes on bond trading. Moreover, before Germany eliminated its
system of taxes, 30% of trading in German government bonds was taking
place in London and another 50% of other DM-denominated bonds was trading
there. To have 25% of Canadian bond trading disappear in response to a
one-basis-point tax would not be surprising.
There is a more important
fact to consider, however. Over 90% of trading volume is in Government
of Canada bonds. Nations that have imposed FTT-type taxes have generally
exempted government securities, largely in recognition of the fact that
the incidence of this tax falls upon borrowers not lenders. For example,
investor A, who is considering buying a government bond, realizes that
he must pay tax upon the purchase and thus he is not willing to pay as
much for the bond as he would otherwise have been, i.e., he demands a
slightly higher interest rate. He also realizes that, should he wish to
sell the bond before maturity, another purchaser would also face a tax
and would take this into account in any offer to buy. And so on... If
the government offers new 10-year bonds to the market, and if those bonds
traditionally turn over five times in ten years, then the present discounted
value of five basis points of tax will be capitalized into the initial
price of the security.
Thus, while the initial
direct revenues from an FTT on bonds might be in the neighbourhood of
$270 million per year, the revenue gain would be eroded over time as the
federal government floated new bond issues. In 1995, the federal government
floated $46 billion in new issues (bonds and Treasury Bills), all of which
would have cost more had an FTT been in place. Over time, as more and
more of the federal stock of debt was issued under an FTT regime, more
and more of the total direct revenues would come from government debt
Canada is a small, open
economy with highly indebted governments. As a nation, we are net borrowers
on international markets. It is very unlikely that an FTT could be used
effectively to lower the real rate of interest that the government must
pay to service its debt. Thus in the end, an FTT is largely a tax that
the government imposes upon itself.
The largest component of
financial transactions consists of trades in short-term debt instruments,
generally referred to as money market securities. Two-thirds of this $6.8
trillion comprises trading in Government of Canada Treasury Bills. This
is also a market distinct from the other two. These securities are very
safe and very liquid. For corporations with good credit ratings and for
governments, these securities generally represent the cheapest form of
borrowing available. Investors, however, see money market instruments
largely as substitutes for cash. They are a place to park money for short
periods of time, and still earn interest, until longer-term strategies
can be put in place. The liquidity provided by transactions costs of one
to two basis points is the reason why trading volumes are so high. For
this part of the market, a one-basis-point tax is a high tax indeed and
will lead inevitably to a search for alternative and tax free instruments
for money management, such as bank deposits.
Money market securities
are very short-term three-month Treasury Bills are common and,
even if held to maturity, would be subject to an FTT of four basis points
per year. If each was turned over only once, in addition to ultimate redemption,
borrowing via these short-term instruments would cost the borrower eight
basis points per year. Since the federal government is the most dependent
upon this market for funds, it has the most to lose by taxing this market.
Very few countries tax money
market instruments. Sweden experienced a 20% drop in trading with a tax
of 0.2 basis points, one-fifth the tax rate being considered in this exercise.
In Switzerland a money market was very slow to develop in the 1980s and
this fact is blamed on that governments taxes on financial transactions.
There is no reason to assume that Canada would be immune to such effects.
Whatever direct revenues the government enjoys from the taxation of money
market transactions, they would largely be offset by higher borrowing
A one-basis-point tax on
money market trades should result in a very substantial drop in the number
of transactions. It would not be unreasonable, at first guess, to assume
disappearance of 50% of trades, at a minimum. As with bonds, the ultimate
incidence of most of the FTT should fall on the federal government. But
these indirect effects on government borrowing costs should be almost
fully felt within one year because of the short-term nature of the securities.
An estimate of the direct
revenues of the federal government in year one is calculated as follows:
This totals $800 million
in total direct revenues.
Ninety per cent of government
bond trading is in federal government securities. If we assume that the
full cost of the FTT on federal bonds was borne by the government and
phased in over 10 years, borrowing costs in year one would be increased
by $24.3 million. In year two they would be increased by $48.6 million,
in year three by $72.9 million, etc.
If we assume that two-thirds
of the FTT direct revenues from money market securities was borne by the
federal government, in line with its share of trading volumes, and the
market adjusted fully within one year, government borrowing costs would
increase by an additional $230 million.
Thus the $800 million in
direct revenues leads only to $545 million in net revenue in the first
year of the FTT. Once the bond market had fully adjusted after ten years,
$800 million in direct revenues would represent only $327 million in net
revenues. This is only one-quarter the amount calculated by multiplying
the base by the tax rate. Moreover, 7.5% of net federal revenues in the
steady state would be borne by provincial governments.
This is admittedly a rough
estimate. Nevertheless it probably overstates federal revenues because
the turnover effects for fixed-income securities in Canada could well
be greater than the figures used here. The calculation does not take into
account the impact of higher borrowing costs on income tax revenues and
higher compliance costs. It also ignores the effects of capital losses
due to the 10-basis-point tax on equities as well as the loss in Canadian
incomes as a result of reducing equity transactions by about $60 billion
per year. Nor does the calculation consider government administration
The above discussion suggests
clearly that an FTT on equity transactions is a very different creature
from an FTT on fixed-income securities. Other countries know this and
that is why they have taxed those securities at lower rates than the tax
on equities: four basis points in Austria, three basis points in Japan,
and three basis points in Sweden. But even these seemingly low rates of
tax have proven to be high for that market. The same is true of taxes
on short-term securities; Switzerland and Sweden are the only two countries
to tax them. The development of the market was seriously hindered in Switzerland,
while a large drop in transactions resulted in Sweden from a 0.2 basis
Despite the difficulties
that might be posed by an FTT on equity transactions, and the possible
negative side effects, that is clearly the most suitable base for the
tax. As a result of its relatively small size, however, the tax rate must
be relatively large to raise a worthwhile amount of income. Once that
happens, the negative effects could grow until they outweighed the benefits
of the tax revenue.
In Canada, through the GST
and other taxes, we tax a whole host of goods and services. Financial
services are not, however, taxed as extensively because of the difficulty
in applying a sales tax to that particular base. If we wish the tax system
to be neutral in its effect on individual economic choices, however, financial
services should be taxed just like other things. Thus there is a legitimate
reason for taxing these services.
A long list of prominent
analysts have justified FTTs on the grounds that we should tax the "big
casino." This argument is in some sense misleading, however. It gives
the impression of gambling, speculation and idle activity that might be
privately beneficial but socially worthless, or even costly. This is a
value judgment and a strong one at that. To the extent that it is valid,
it applies only to a small subset of the $11 trillion potential tax base
in question. It is not correct to suggest that all financial transactions,
or even a large part of them, possess such gambling characteristics, particularly
if we consider larger measures of the tax base.
Thus to justify taxing financial
transactions needs more than a reference to the "big casino."
One obvious justification would be a demonstration that an FTT was a better
tax than the one it replaced or helped to replace.
But is the FTT a good tax?
The international experience is somewhat mixed in this regard. Japan appears
to have successfully maintained an FTT over time and has raised substantial
amounts of direct revenue from it. Although these taxes have had some
negative effects on the Japanese financial market, the government considers
them to be insufficient to outweigh the benefits. The UK seems to have
raised ample revenue while at the same time witnessing a thriving and
growing financial industry. Despite this, however, the UK believes that
more can be achieved without the tax and has indicated a desire to get
rid of it.
Sweden, on the other hand,
appears to be a classic example of an experiment gone wrong, while Germany,
like many other countries, has decided that the costs outweigh any benefits
from this type of tax.
Is Canada more like Sweden
and Germany or is it more like Japan? Canada is a small, open economy
with very strong capital mobility. It is also a very heavily indebted
economy with heavily indebted governments. Japan is the opposite, however,
as well as being culturally different from Canada and the rest of the
While the successful implementation
of an FTT depends on a variety of factors, it would be enhanced if our
financial markets and their competitors had similar taxes. This is unlikely
to be the case for Canada; the United States has not indicated a commitment
to such a tax and other countries are moving in the opposite direction.
Canadian providers of financial services today face fierce competition
from the United States, where costs are lower. An FTT would exacerbate
There is, however, a further
issue that is important in this discussion. FTTs are appealing because
of the extremely large size of their potential tax base in relation to
the size of the economy. Whether it be $11 trillion, $23 trillion
or even $53 trillion, financial transactions dwarf real economic activity,
measured at $750 billion. The FTT could be imposed at a very low rate
because of this large tax base, and some believe that consequently few
distortions would be caused and the tax would be relatively painless.
Whatever kind of tax is
employed, the result would be a transfer of real spending power from the
private sector to governments. Someone must pay, and not from financial
transactions but from income or net assets. In the long-run, GDP is the
best measure of ability to pay - the total value of financial transactions
is not a measure of ability to pay. Thus a $1 billion tax on $11
trillion of financial transactions reduces the private sectors spending
power by as much as a $1 billion tax on something else, even if done in
small increments and if hidden from view. Its incidence on individual
taxpayers and the consequent effects on the economy might be different,
but in the end it is another $1 billion tax on GDP.
An FTT, even at a very small
rate, can cause distortions. The financial transactions shown in Table
1 amount to 14 times annual GDP and are almost 100 times as large as the
GDP attributed to the finance, insurance and real estate sector. Financial
transactions in their broadest sense (i.e., using the $53 trillion estimate)
are almost 500 times as large as the value added attributed to the finance,
insurance and real estate sectors. Each transaction, therefore, contains
only a small amount of value added and would be very sensitive to price
Economic theory suggests
that the burden of an FTT would fall upon those who used financial capital
rather than those who supplied it when that capital was highly mobile
and when the nation imposing the tax was small and a net borrower. Thus
Canadian borrowers would pay the tax, as opposed to Canadian and foreign
savers. The largest Canadian borrowers are, of course, our governments.
While the implementation
of an FTT would cause existing investors in Canadian financial securities
to face a one-time capital loss, future investors could not be forced
to bear such costs as long as there were non-taxable alternatives available
Finally, the implementation
of an FTT must consider one factor that has received scant attention here.
A federal FTT would constitute, to some extent, a direct tax on provincial
treasuries. If the tax applied to provincial government securities, it
would directly raise the cost of provincial borrowing. If the tax caused
asset prices to fall, or if it otherwise raised business costs, it would
erode the income tax base of provincial governments and hence lower their
revenues. Any federal government considering the implementation of a financial
transactions tax might want to take such provincial impacts into account
when designing it.
J. Hemeon, "Group Campaigns for Tax on The Big Casino:
Aiming to Replace GST with New Levy on All Financial Transactions,"
Toronto Star, 24 March 1996, p. D1.
A basis point is equal to one-one hundredth of a percentage point.
"Brazil: Financial Transactions Tax," International Tax Digest,
Vol. 5, No. 3, May-June 1993.
J.M. Keynes, The General Theory of Employment Interest and Money,
Harcourt Brace and World Inc., New York, 1935, Chapter 12, p. 159.
L.H. Summers and V.P. Summers, "When Financial Markets Work Too Well:
A Cautious Case for a Securities Transaction Tax," Journal of
Financial Services Research, 1989, p. 261-86.
J.J. McConnell, Securities Transaction Taxes: What Would Be Their Effects
on Investors and Portfolios?, Catalyst Institute, Chicago, Ill., July
P. Shome and J.G. Stotsky, Financial Transactions Taxes, IMF Working
Paper WP/95/77, August 1995.
C.S. Hakkio, "Should We Throw Sand in the Gears of Financial Markets?"
Federal Reserve Bank of Kansas City, Economic Review, Second Quarter,
R.G. Hubbard, Securities Transactions Taxes: Can They Raise Revenue?,
Catalyst Institute, Chicago, Ill., July 1993, p. 5.
An indication of how one product might mimic the characteristics of another
is Citibanks introduction in 1993 of a certificate of deposit, equivalent
to our GICs, which offered an interest rate that was linked to the performance
of an index of stocks. See: B. Granito, "New Derivatives Products
are Surprisingly Complex," Wall Street Journal, 9 April 1993.
Canadian banks also offer such products. Scotiabank offers a two-year
GIC whose return is equal to the performance of the Toronto 35 Stock Index.
The minimum return on this GIC is 0% over two years and the maximum return
A question that ultimately needs to be addressed is whether the FTT liability
is to constitute an expense for income tax purposes. If so, then income
tax revenues would be reduced directly whenever the tax was paid.
G.W. Schwert and P.J. Sequin, Securities Transactions Taxes: An Overview
of Costs, Benefits and Unresolved Questions, Catalyst Institute, Chicago,
Ill., April 1993; McConnell (1993); Hakkio (1994).
S.R. Umlauf, "Transaction Taxes and the Behavior of the Swedish Stock
Market," Journal of Financial Economics, 33 (1993), p. 227-240.
Turnover elasticity measures the responsiveness of turnover to changes
in costs. An elasticity of -0.5 indicates that a 1% increase in costs
will reduce turnover by 0.5%. An elasticity of -2 indicates that a 1%
increase in costs will reduce turnover by 2%.
A.W. Lo and J.C. Heaton, Securities Transaction Taxes: What Would Be
Their Effects on Financial Markets and Institutions?, Catalyst Institute,
Chicago, Ill., December 1993.
P.B. Spahn, International Financial Flows and Transactions Taxes: Survey
and Options, IMF Working Paper WP/95/60, International Monetary Fund,
Washington, D.C., June 1995.
United States Congressional Budget Office, Reducing the Deficit: Spending
and Revenue Options, Washington, D.C., February 1990, p. 388-389.
K.A. Froot and J.Y. Campbell, Securities Transactions Taxes: What About
International Experiences and Migrating Markets?, Catalyst Institute,
Chicago, Ill., July 1993.
Toronto Stock Exchange, 1995 Official Trading Statistics, Toronto.
The Canadian convention regarding billion and trillion, which is the same
as the American usage, is employed here. One billion is equal to one thousand
millions. One trillion is equal to one thousand billions. Thus one trillion
is equal to one million millions.
Investment Dealers Association of Canada, Capital Market Statistics,
Toronto, March 1996.