Germany’s Plans for a Financial Transaction Tax

December 16, 2019

Last week, German Finance Minister Olaf Scholz sent his plans for a financial transaction tax (FTT) to ministers from nine other EU member states. The group of 10 countries—Austria, Belgium, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia, and Spain—has continued discussing taxing financial transactions after plans for an EU-wide FTT halted in 2011. Belgium, France, and Italy already levy an FTT.

Arising from debates triggered by the last recession, the tax is intended to make financial markets more stable by discouraging excessive risk-taking and to raise tax revenue. One of the reasons for making it a multilateral rather than unilateral effort is to mitigate migration of trading activity.

Scholz proposes an FTT at a rate of 0.2 percent on the transaction value of purchases of shares in domestic companies valued at over €1 billion (US $1.11 billion). For example, if shares are purchased for €1,000, one would be charged €2 on the transaction. An exemption for Initial Public Offerings is planned and the tax would only be levied on shares—derivatives and debt instruments would be excluded.

Over 500 businesses across all 10 EU member states would be in scope, with 145 in Germany. The tax is estimated to raise €1.5 billion (US $1.67 billion) annually, which would largely be used to fund pensions.

The design of the tax raises multiple issues. By only taxing shares, an FTT can be avoided by simply switching to derivatives trading. For example, the United Kingdom’s FTT does not tax derivatives and evidence shows that derivatives trading has grown significantly. Since Germany’s proposed FTT only targets shares, the tax would potentially result in similar substitution across financial instruments and thus raise less tax revenue.

One argument for an FTT is to decrease price volatility by decreasing speculative trading. However, it is unclear whether this would be the case. An FTT increases both explicit and implicit transaction costs, which increase volatility. This phenomenon could offset the decrease in speculative trading’s beneficial effect on volatility. Research found the French and Italian FTTs have had no impact on intraday volatility.

In addition, the proposed FTT could lead to distortions across sectors. Since the tax is levied each time a share is sold, it results in so-called tax pyramiding. Assets that are traded more frequently will have higher effective tax rates than assets that are traded less often, distorting decision-making particularly for industries that are more transaction-intensive. The company value threshold of €1 billion creates an additional distortion by discriminating in favor of smaller firms.

The proposed FTT also increases the cost of equity, further incentivizing the use of debt over equity through the tax system. (Traditional corporate income tax systems allow tax deductions of interest payments but not of equity costs, effectively favoring debt over equity finance.)

A 2011 paper by the IMF suggests that financial transaction taxes (synonymously, securities transaction taxes or STT) are “an inefficient instrument for regulating financial markets and preventing bubbles” and that “more efficient tax measures should […] be considered before an STT.” The paper also notes that if a country decides to implement a financial transaction tax, it should levy a low rate on a broad base that includes all securities and derivatives transactions to minimize avoidance and financial market distortions.

Taking these considerations into account, policymakers should exercise great caution in deciding whether to enact an FTT. But if Germany and the other nine EU member countries do decide to implement such a tax, the tax base should be broadened to include derivatives. Otherwise, the tax can be avoided by switching to derivatives trading, an avoidance strategy that could decrease tax revenue substantially and increase financial market distortions. However, broadening the base would still leave impacts on volatility and the cost of equity unaddressed.

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