The Viability of FTTs Within Post-Pandemic Tax Reforms

As the saying goes, "In this world nothing can be said to be certain, except death and taxes." In the post-coronavirus world, increased taxes in some shape or form are almost a given as governments build recovery plans from the economic destruction that the pandemic has brought. One such tax being proposed in various quarters is a financial transaction tax, or FTT.

FTTs exist in some countries and have been tried in others, and they essentially do what they say on the tin: Each trade of a security will trigger a tax liability. They have been an emotive topic, with investors and asset managers in every country where one has been proposed protesting that it will see traders vote with their feet and execute their business in other markets instead.

Governments find FTTs attractive as a means of raising significant revenues from relatively low taxes on a large universe of payers. The challenge for policymakers in today's global markets, with sophisticated technology and complex financial instruments, is designing an FTT without creating self-defeating market distortions.

In a recent whitepaper, we analyze proposed, existing, and repealed financial transaction tax approaches around the world to address the following: How would an FTT affect ordinary investors? Can an FTT achieve a targeted behavioral change or revenue goal?

The Direct Cost to Investors Is Small, but the FTT Design Can Create Unintended Incentives

A financial transaction tax can impact retail investors in two distinct ways: 1) by increasing the cost of investing and 2) by discouraging them from using the products that create more taxes than others. While analysts disagree on how much an FTT will cost retail investors, less attention has been given to the preferential treatment the tax can create for certain investment vehicles and strategies, which could limit the products brought to market and influence the advice given to investors.

For fund investors, as John Rekenthaler recently discussed, the direct cost is relatively small. We further assessed the impact of a 0.1% FTT on all stocks for active and passive portfolios spanning three Morningstar Categories and found this to be true, although certain investment styles and strategies experience greater losses.

Specifically, we found a clear disparity between the impact on passive and active funds and between strategies with broader and narrower investable markets. Across all three categories, the passive fund experienced a smaller reduction on return than its active counterpart. This occurred regardless of their relative performance, with the passive foreign large-blend exchange-traded fund returning less than its active complement and the passive large-growth ETF surpassing its active peer.

The variation in return reductions for passive funds across the different investment strategies also showed an increased impact on funds with smaller or more constrained investable markets and markets with more turnover. Considering just the passive investments allowed us to draw conclusions based on the category of the fund and remove the element of what strategic decisions an active manager might make. The U.S. large-growth ETF, with the most stable holdings, experienced a minimal reduction in return, while the U.S. small-blend ETF's return reduction was double that of large-growth and the foreign large-blend ETF's was more than 4 times as much.

Existing FTTs Focus on Large Stocks, Raising Minimal Revenue

The current landscape of financial transaction tax schemes spans several continents and provides examples of different designs and implementations of the tax from which we can learn. Although there is variety in the rate and payer of the tax, most active FTTs exclusively tax stocks, with some limiting the scope to an even narrower segment of the market. As a result of the narrower scope, the revenue these taxes raise is limited and there are avenues for investors to avoid taxation by moving to other asset classes.

Efforts to create an FTT in the European Union stalled after the financial crisis. A subset of countries then pursued a scaled-back scheme, but nearly 10 years later those discussions are still ongoing, with one of the sticking points being how to ensure a minimum level of revenue for each participating country. This is an understandable concern given the scale of tax revenues that France and the United Kingdom see from their existing transaction taxes.

With each raising less than 1% of total tax revenues and less than 0.2% of the respective countries' gross domestic product, the design of the taxes is partially responsible for the restricted revenue. By applying the tax only to shares, an FTT can be avoided by switching to derivatives trading. The UK stamp duty does not apply to derivatives (and derivatives trading has grown significantly), although the Labour Party proposed a new FTT that would include them prior to losing the last general election in 2019.

In some cases, new transaction taxes are floated with the idea of curbing high-frequency trading as an auxiliary goal. In the French system, the role of high-frequency traders in providing liquidity to the market is acknowledged, and they are exempt from the FTT. For the purposes of raising revenue or treating an FTT as a sin tax, it is clearly disadvantageous to exclude high-frequency traders. An argument in favor of FTTs is their ability to decrease price volatility by decreasing speculative trading. However, this remains largely unproven and could result in the loss of tighter price spreads that have been brought about by more trading.

Perhaps because many of its governments have lower structural deficits, the use of FTTs is lower in Asia. This region does, however, supply the outlier of active FTTs in terms of revenue raised, as Hong Kong generates a significant portion of its total tax revenue from its transaction tax.

In 2020, Hong Kong announced the waiving of its stamp duty on stock transfers for primary market ETF activities in a concerted effort to attract more ETFs to the market. The stamp duty for trading ETFs in the secondary market in Hong Kong has been waived since 2015. However, as it narrows the focus of its FTT, Hong Kong is considering slightly raising the tax rate on the remaining applicable securities. In early 2021, Hong Kong introduced legislation that would increase the stamp duty rate from 0.10% to 0.13% for all Hong Kong stocks.

In its current form, Hong Kong's transaction tax raises revenue equal to more than 1% of its GDP, a rate more than 4 times greater than we saw in any other country we analyzed. There are many contributing factors to this outsize revenue, including China's use of Hong Kong's markets for interacting with other international markets and the longer time for which this tax has been active, as it was originally introduced in 1981.

Broader FTTs Could be Implemented Successfully, but Careful Construction Is Needed

These examples demonstrate that it is possible to implement an FTT without severe detrimental effects for the local market and investors, but if the goal is to raise significant revenue, policymakers need to design the tax conscientiously as they expand the scope beyond stocks. Even FTTs with such a narrow scope sometimes fail--Sweden's 1980s foray into FTTs is a classic example--and always require monitoring to ensure the rate is at an appropriate level.

When looking to generate more tax dollars from an FTT, the scope of the transactions taxed needs to be considered to avoid investors altering their behavior drastically to sidestep the tax. Additionally, any incentives created by including and excluding elements of the investment landscape in the scope should be weighed against the benefits of the additional revenue and the potential for these incentives to negatively impact investors. Finally, the magnitude of the tax must be balanced between a high enough level to generate the revenue needed and a low enough level to not create a significant barrier to market participants.

The many factors at play present a challenge for policymakers when considering implementing any new FTTs. However, with thoughtful decisions and ongoing oversight, we believe it is possible for a broader FTT to be implemented without causing long-term harm to investor outcomes.