What Was the EU Thinking?

Until recently, I thought the European Union ministers were intelligent, careful and methodical. Not any more. Seventeen members of the EU have been given the go-ahead to tax financial transactions, meaning that any time someone sells or buys a stock or bond, they'd pay a tax of 0.1% on the transaction. Any time someone transacts a derivative, it's only 0.01%. {See Reuters story.)

Germany, France, Italy and eight other members are expected to give their approval and start raking in huge amounts of income from the taxes to shore up their depleted revenues.

If a trade takes place outside the eleven countries signing onto the tax, the tax would still be due on the portion of the trade originating from the eleven nations.

Think about it. If you were in Britain or any other nation outside the group of eleven, would you EVER buy or sell on an exchange in Germany or France? Considering that London is generally regarded as the financial center of Europe, why would anyone outside the eleven transact a single trade inside? In fact, if the trade took place in Hong Kong, how would the eleven collect? I'm not even sure pure US firms would feel it necessary to bother collecting and paying.

It doesn't take a genius to see where this will lead. Remember that in Europe there is no separation between banks and stock brokers like in the US. The banks are the brokers. Essentially, the eleven are paying the world to leave their banking systems for greener pastures. The miniscule amount of money they will reap from this tax is dwarfed by the massive outflows of capital that await them.

Defenders of the tax say that it is so small that no one will care. This is a foolish argument for two reasons. (1) I traded options when they first moved onto exchanges in the US. I did all kinds of spreads and other more exotic strategies to make money. It was easy in the early days of the exchanges, but it got progressively harder as time went by. Markets corrected very efficiently to make many strategies uneconomical. Commissions and taxes on the trades are referred to as "friction." If there's too much friction, a trade that on paper looks to be economically viable becomes unappetizing. Today, in the US, you cannot engage in arbitrage trades (Wikipedia has a decent devinition of "arbitrage" if you need it) unless you are moving massive amounts of money because there are higher proportional costs at lower volumes and the friction eats you alive. What seems like very small fees in Europe will be enough to tip the scales of arbitrage so that no one paying the eleven nation tax will be able to play -- their friction will be greater than their competitors and they will never pull the trigger on trades that UK bankers gleefully grab. Once the UK has feasted on the blips in pricing everything will move back to theoretically nominal and there will be no trades until the next blip. Because arbitrage trades make up a large percentage of all trades, the exchanges outside the eleven will prosper and those inside will wither.

And (2), if no one cares that taxes are so low and they continue to trade, you can pretty well count on the eleven increasing the taxes. The income shortfalls in the EU aren't getting any easier for a generation. Markets understand this and even if the bankers think the taxes aren't too bad now, they know they'll get worse in the future and take corrective action. Remember, the maximum income tax in the US was 7% when we started. It isn't now. The threat of rising taxes will move all the money that is capable of moving outside the taxing arena. And money is hugely more mobile today than in years past.

There are a lot of politicians who use steady-state analysis to pontificate on how much this tax or that tax will raise. They assume that after they enact the tax no one will change their behavior. Inevitably, higher taxes do change behavior and mess up the careful calculations of the steady-state analysts. Considering that France has about a dozen actions against multinational corporations for failing to pay the proper amount to France for income earned in other countries, it is inconceivable that they don't know that their current policies have driven business outside the country. One of the more humorous episodes involves Gerard Depardieu, one of France's most famous actors, who has taken out Russian citizenship to avoid France's new, higher taxes. Even if France is successful in extracting money from careless corporations who didn't cook their books properly, the next generation of comptrollers will figure out how to escape their clutches. Count on it. The higher France raises their income taxes on corporations and individuals, the more corporations and individuals will leave to be taxed in greener pastures. Yes, in the short term, raising taxes does usually raise more revenue, but it is never as much as the steady-state analysts said it would be. And the harder they chase the money, the more elusive it becomes. At very high rates of taxation, tax revenues all but disappear. Who wants to work hard if 90% goes to the government? If you think 90% is way too high an example, the maximum income tax rate in the US from 1950 to 1963 was 91%, except for a blip to 92% in 1952-53. Fortunately for the US, patriotism after World War II, tax loopholes (directing investment into oil exploration and real estate development) and the difficulty of moving money at that time made the tax rate palatable to the populace. It would have a far more devastating effect today.

Politicians are elected for 2-6 years. They are elected by a public who are mostly poor and middle class. Their first job is to get reelected. Frequently that means pandering to the vast majority of the electorate who have no conception of how easy it is for the wealthy to move their millions. The last thing politicians are concerned about is doing what is best for the next 50 or 100 years for the economies they govern. Yet, keeping investment money inside the economy is one of the most critical functions of government. Just not of the politicians who run their governments.

January 21, 2013