The tax on all financial transactions between financial institutions proposed on September 28th by the European Union raises a host of issues. But it seems to suffer from at least two basic flaws.
The EU implies that one justification for the tax is the involvement of a broad range of financial transactions in the financial crisis of 2008. However, transactions between financial institutions were not in any general sense responsible. As I argue in my recent article on credit risk transfer, it was only a narrow type of cash and synthetic CDOs that transferred the risk of subprime mortgage-backed securities that caused the massive losses and runs on financial institutions. It was not interest rate swaps, credit default swaps on corporate bonds, futures, leveraged loans, or an extremely wide and diverse range of other transactions that would nonetheless be subject to the tax. While it is true that reform efforts should be forward looking and not merely "fight yesterday's battles," that bit of wisdom should not be a blank check for overly broad measures.
The tax may also be redundant to the extent it is used to reduce systemic risk and not just raise tax revenues or harmonize pan-European tax regimes. Take the case of over-the-counter (OTC) derivatives. Under the Basel III global banking reform efforts, OTC derivatives will be subject to a higher capital charge (page 4) because they are not cleared with a central counterparty. In addition, OTC derivatives trades by dealers and other nonbanks will be subject to new capital, reporting, and conduct requirements by the European Market Infrastructure Regulation proposal. The purpose of these additional tax-like capital charges and requirements, and a host of other regulatory and industry-led efforts, is to reduce systemic risk. Accordingly, to the extent a tax on derivatives transactions is an attempt to do the same, it would be duplicative and for that reason should be viewed with skepticism. Non-tax reform efforts more directly tied to reducing systemic risk will likely be more effective.
