17 September 2019

Why a financial transaction tax makes no sense

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The idea of a financial transactions tax is rearing its ugly head again, with the ever-misguided John McDonnell once more voicing his support last week.

What passes for the logic of this proposal is that there is a lot of turnover in the London financial markets. So, if each and every transaction is taxed a tiny bit of a few pennies the Exchequer will rake in lots of money to do wondrous things – £7bn or so according to some estimtes. There are a few problems with this contention, to say the least.

The first is the idea that an FTT is comparable to the stamp duty already charged on share trading. This isn’t, as is assumed, paid by  City fatcats. Instead it ends up hitting pension funds, which ultimately means old people having less in their retirement pots – but that’s not exactly an appealing sell to the electorate, is it?

A much more fundamental problem is that an FTT won’t raise any extra money. If anything, it will mean lower revenues. Even the European Union said as much when they evaluated their own proposal for such a tax. Making investment transactions more expensive reduces the amount of investment, which in turn has an impact on the tax take.

Governments know this, by the way, which is why government bonds – gilts – are usually excluded from FTT-type proposals. That is an admission that an FTT makes raising capital more expensive and ministers quite understandably don’t want to apply that to themselves.

Then there’s the justification put forward by the Guardian’s economics editor, Larry Elliott.

The cost of raising finance is the same as it was in the late 19th century; all the gains from technology and economies of scale have been grabbed by producers rather than consumers. 

This is so far from being true as to be a reversal of it. These days savers can put their money into an index fund at a cost of some handful of basis points – 0.04% seems to be one charge – which is really rather lower than what was on offer in the Victorian age. That might be why we actually have pensions, unlike those in the Victorian age. Note too that our great-great grandparents certainly weren’t able to invest directly in a share at a fee as low as £7 – not once inflation is taken into account.

Elliott’s claim is just as far off the mark when one looks at the other side, the price of raising funds as a capital consumer. WeWork may not be the finest investment ever offered to man, as recent changes in the IPO price are showing, but it has raised $8.4 billion in capital so far. Something that the couldn’t have been achieved in the 19th century, even taking inflation into account.

But here’s the true nonsense about the FTT. The thought is that there’s lots of trading, shuffling, which doesn’t do much of anything. Much ire is aimed at high frequency trading, HFT. Just ‘bots trading back and forth for fractions of a penny each time. We want to tax this out of existence because it doesn’t achieve for anyone other than the capitalist pigdogs.

Well, yes, quite. Which is to entirely misread what is going on. More trading back and forth for fractions of a penny reduces the spread – the difference between buy and sell on offer – because that’s what greater liquidity does. Spreads, those differences between the price individuals can buy and sell at – have collapsed in the past few decades, not despite but because of the rise in paper shuffling. Today we can usually trade with no spread at all on larger stocks.

So, who is it that has lost from this spurious and wasteful trading? As it happens, it’s the market makers, producers in The City. They used to make fat returns off the differences in buy and sell prices. Now they don’t exist. So much so that in New York Goldman Sachs bought an equities market maker for $8 billion then closed it down a few short years later. Profits had evaporated because even the possibility of revenue had.

A clear-sighted analysis of what has happened in finance should go something like this. Technology and economies of scale have reduced the cost to consumers of saving through financial markets. The proposed solution of an FTT is to tax that benefit out of existence, while also losing tax revenue at the same time.

And to think that there are those who claim that the Labour Party isn’t quite up to speed on modern economics. Hush, how could anyone say so?

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute