Misleading study by distorts costs of the Financial Transaction Tax (or ‘when draining a swamp, don’t expect the frogs to help’)

In February 2013, the EU formally launched the process for the introduction of a Financial Transaction Tax (FTT) via the Enhanced Co-operation Procedure with the participation of eleven Member States. In the last few months, the financial sector has mounted a concerted effort to undermine the FTT. Reports have been produced to authenticate negative conclusions relating to the impact of the tax. In addition to the all too-familiar scare stories that the FTT will fall on small savers and pensioners, a recent study by Goldman Sachs (GS) presents two new arguments: the tax burden on the sector will be exorbitant and that a vast amount of this enormous figure will come from the taxing of the REPO market (as described below).

Goldman’s calculations: intellectually flawed

The ‘Pro-forma’ approach On 1 May 2013, Goldman Sachs published a new report in which it alleges that the FTT would result in an additional tax burden to 42 major European banks of €170 billion.1 This figure is five times as much as the EU Commission predicts the 11 nation FTT will raise (€34 billion). This is mostly the result of taxing REPO transactions, which GS allege will raise €118 billion, followed by derivatives trading: €32 billion, shares: €11 billion and government bonds: €4 billion.

GS claim French banks would be the hardest hit, paying some €61 billion under the new FTT, with German banks paying €35 billion – including a Deutsche Bank contribution of €28 billion. The six banks with the highest percentage burden2 vis-à-vis their current tax bill would be Natixis (423%), Commerzbank (381%), Deutsche Bank (362%), Crédit Agricole (220%), Société Générale (211%) and BNP Paribas (168%).

The extremely high figure of the tax burden claimed by GS is the result of the deliberate way they have contrived to calculate the numbers, which according to Stephan Schulmeister of the Austrian Institute of Economic Research, “is obviously motivated by the interest to let the FTT burden look as big as possible.”3 They have simply taken the total turnover of the sales and purchases of all assets on which the FTT would be charged (using 2012 figures) and applied the tax rates of 0.1% for shares and bonds and 0.01% for derivatives to all of them. GS describe this method of calculation as the “pro-forma” approach.

The reason this method is flawed is that it ignores price elasticity. The FTT by making trades more expensive will have an impact on market behavior making a proportion of transactions no longer profitable (depending on the margins of profit in the market and the rate of the tax). Consequently, there will be a reduction in the number of trades. This needs to be reflected in the way the sum is calculated. The took into consideration such elasticity dynamics in the financial markets when making its calculations of prospective FTT revenue. Goldman Sachs, by ignoring price elasticity, create a false impression of the magnitude of the impact distorting the cost of the FTT to the financial sector by a factor of five.

REPOs and the ‘effective annual tax rate’ This is not the only crude manipulation of figures in the report that leads to substantial inflation of numbers. There is another device employed that leads to a significant distortion, this time relating to the taxation of a type of transaction known as a REPO (a sale and ). REPOs are de facto short-term loans that banks conduct with one another. They have extremely short maturities,

1 Goldman Sachs. Europe: Equity Research: Financial Transaction Tax: How severe? May 1, 2013 2 Profit before tax 3 We follow here the arguments from chapter 4.3 of a new study by Dr Schulmeister of the Austrian Institute of Economic Research (WIFO). The study is due for publication in July 2013. often no longer than a few hours. Loans are, in fact, exempt from the FTT legislation, but REPOs are legally considered as trading activity (rather than loans) and hence liable to taxation.

The GS report employs a methodology which relates the annual FTT payments to the average REPO value. It calls this the ‘effective annual tax rate’. Schulmeister argues that:

“By this ‘semantic trick’ one can document astronomically high ‘tax rates’ as these rates become higher the shorter the financing period of the REPO…By relating the annual tax burden not to the annual transaction volume but to the size of the average transaction, GS Research lets the effective tax rate appear much bigger than it actually is. For tri-party-REPOS which are turned over 3 to 5 times per day, GS Research arrives at an ‘effective annual tax rate’ for the FTT of 360% (see GS report, 2013, exhibit 12 on P.19).”

The GS report therefore employs two devices to distort the overall tax burden to the financial sector by firstly not taking into account price elasticity and secondly by a using a methodology relating to the REPO market that grossly inflates the total.

REPOs more generally: addressing widespread speculative risk

A fundamental question does present itself: why do we need these extremely short-term loans? What economic purpose do they serve? It is clearly not a company or a bank that might be financing a project in the real economy or covering an area of risk through hedging activities. For the former, the duration is usually a matter of years; for the latter, a few weeks.

On the contrary, REPO loans are super short maturities of essentially a speculative nature, where a fast-rate differential here or price fluctuation there, makes for a quick profit. Or, they may be used in order to identify securities for the business of speculation for a few hours. In addition, the REPO loan is often used to serve as leverage. You borrow several hundred million for a few hours to achieve a higher dividend to be able to repay the principal and make a profit. Finally, you may need REPOs to fund ‘short selling’ – a speculation on the fall of asset prices - a particularly risky business model that is fraught with dangers to overall financial stability.

Schulmeister argues that REPOs played a major role in the crash of 2008, because they first led to bubbles and then to a domino effect. However, the problem has been given no attention in previous efforts at reform, neither in regulatory measures in the USA, nor in the EU. The FTT is a means of correcting this.

Although the figures from Goldman Sachs are brazen in their naked self-interest, it is of course true that the introduction of the FTT would result in a restriction of speculation in respect of REPO transactions for the first time. But that is both desirable and good. For the purpose of the FTT is not only to achieve tax revenue, but also to disincentivise certain types of trading, bringing greater stability to financial markets and, more than this, increased protection from economic crashes in the future. This is a long overdue consequence of the experience of the financial crisis.

David Hillman, Stamp Out Poverty Peter Wahl, World Economy, Ecology and Development (WEED)

27 June 2013