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Frequently Asked Questions on Securities Transaction Taxes
General Questions on Securities Transaction Taxes
1. What is a securities transaction tax (STT)?
A securities transaction tax is a tax imposed on securities transfers, including, generally, purchases and sales. The tax could apply to the value of trades in stocks, bonds, derivative instruments, mutual funds, exchange-traded funds (ETFs), and other securities.
2. What is ICI’s position on STTs?
While an STT can be structured in a variety of ways, ICI believes that any such tax could harm individual fund investors who are investing to meet retirement, education, and other financial goals. Click here for more detail on ICI’s position on STTs, particularly the following points:
- An STT would be a tax on all investors, not just short-term investors.
- If applied to money market funds, such a tax would severely damage the industry.
- In addition to the direct costs of the tax, the tax is likely to have negative effects on all investors in the market and the broader economy.
3. What benefits do proponents of an STT expect?
Proponents of STTs cite the fact that an STT would raise revenue for the government. Supporters of STTs also believe that these taxes will improve the functioning of the markets and help long-term investors.
4. How would the proponents of an STT expect these benefits to be achieved?
Supporters of STTs believe an STT would improve market functioning and help long-term investors in several ways: by reducing stock price volatility; discouraging what they perceive to be a short-term focus on the part of investors; and reducing “financial engineering,” or the creation of complex financial instruments. These arguments are advanced by such advocates as the Aspen Institute, the Economic Policy Institute (EPI), and the Center for Economic and Policy Research (CEPR). (See Claimed Benefits of a Securities Transaction Tax, Questions 14–18 below.)
5. Does experience and academic research support the views of STT proponents?
The short answer is no, as is detailed in this FAQ and other materials.
There is no evidence that imposing a transaction tax reduces stock price volatility (see Question 15).
An STT could discourage trading, particularly short-term trades. But there is little evidence to support the view that long-term trades are better for markets or for investors than short-term trades (see Question 16).
It is not clear that an STT would discourage financial engineering, and it might even encourage the practice, as financial firms design products that reduce or avoid the STT (see Question 17 below).
6. What would be the direct impact of a securities transaction tax on fund investors?
An STT that applies broadly to stocks and bonds would raise funds’ costs and reduce investment returns for shareholders in mutual funds, ETFs, and closed-end funds.
Funds trade their portfolio securities routinely as they invest shareholder cash, meet shareholder redemptions, and adjust fund portfolios. An STT would raise transaction costs on those trades, and that cost would reduce shareholders’ returns.
If a securities transaction tax does not exempt trades in mutual fund shares, it would subject mutual fund shareholders to double taxation. A fund buyer would pay tax on both the purchase of fund shares and on the fund’s portfolio trades. Shareholders in money market funds could be hit especially hard by the tax because many of these shareholders buy and sell shares frequently, as they use these accounts to manage their cash balances.
In addition to its direct costs, such a tax is likely to reduce market liquidity (that is, the degree to which an asset can be bought or sold without affecting its price) and widen bid-ask spreads, further increasing investors’ transaction costs.
7. How would a securities transaction tax affect the markets generally?
No matter how such a tax is structured, it would create market distortions that would reduce the efficiency of markets for all participants, including fund investors. The tax would reduce market volume and could have a negative impact on liquidity and price discovery—the process of determining market prices through the interaction of buyers and sellers.
8. How would a securities transaction tax reduce market volumes?
If the United States imposed an STT, market volume on U.S. exchanges would decline, as some trades would become too costly to execute. Other trades would move off U.S. exchanges, as investors either move trading activity to other, lower-tax venues or trade more in alternate securities.
Securities transactions affected by the tax could move offshore. This happened, for example, after Sweden imposed such a tax and a large portion of trading in Swedish stocks migrated to London.
If the tax did not exempt trades made by intermediaries—such as market makers for individual securities—there would be an incentive to move trades from the public exchanges to alternative trading venues that directly match buyers and sellers.
Volume on U.S. exchanges would also decline if investors could avoid or reduce the tax by trading alternate securities. For example, even if the same tax rate applied to derivative transactions, if the tax was imposed on the net payments generated by derivative contracts rather than on notional value of the contracts, entering into a futures contract could allow an investor to replicate the returns of directly owning equity but reduce the amount paid in transaction taxes. Similarly, if the tax were assessed on the notional value of derivative contracts but at a lower rate, entering into a futures contract could reduce transaction taxes relative to owning equity directly.
9. How could a securities transaction tax have a negative impact on liquidity and the price discovery process?
The tax could cause intermediaries, such as dealers and market makers, to be less willing to provide liquidity to the markets.
One way these intermediaries profit is by buying securities at a lower price (the “bid”) and selling them at a higher price (the “ask”). An STT would reduce intermediaries’ profits and discourage them from trading unless spreads between bid and ask prices widened by at least the amount of the tax.
Price discovery could be impeded because investors would also be discouraged from trading. Investors trade when they obtain information that affects their estimate of the fundamental value of a firm. To overcome the increased cost of trading, investors would require a higher expected rate of return before they trade. That is, to act on new information, investors would require either a greater discrepancy between the stock’s current market price and their new estimate of the fundamental value of the firm, or more certainty surrounding their estimate. The tax’s barrier to trading would result in less interaction between buyers and sellers. Generally, greater interaction in markets results in more accurate price discovery.
10. Doesn’t the fact that other countries have securities transaction taxes reduce investors’ incentive to move their trading overseas?
Short of a worldwide agreement on a uniform securities transaction tax, imposition of an STT in the United States will create incentives for investors to trade elsewhere. Indeed, imposition of an STT in the United States—the world’s largest securities market—has the potential to prompt the development of a dominant global tax-free exchange.
11. Couldn’t a mutual fund minimize the effect of an STT by making fewer portfolio transactions?
To operate efficiently, a mutual fund must make routine purchases and sales of securities to invest shareholder cash flows, obtain cash to meet investor redemptions, and adjust fund portfolios to implement the fund’s investment strategies as market conditions and the value of portfolio securities change. Introducing a tax incentive to avoid trading could distort funds’ decisions and make fund operations less efficient and more costly.
A stock fund’s adviser already has strong incentives to ensure that it doesn’t engage in portfolio trading—whether “too much” or “too little”—that harms the fund’s performance. If the cost of a fund’s trading activity exceeds the benefits in terms of improving the fund’s performance, investors may leave the fund.
12. Could an STT be designed so that that it is difficult to avoid? Could an STT be designed so that it is easy to administer?
A transaction tax could be difficult to avoid or easy to administer, but it is unlikely to be both.
The tax could be avoided simply by not trading. Indeed, one of the rationales for the tax is that it would reduce trading. However, the tax could also be avoided by changing the venue of the trade or the nature of the securities traded, as explained in the answer to Question 8 above.
To minimize avoidance, the base of the transaction tax would need to be as broad as possible. However, broadening the base would make the tax harder to administer. To discourage transactions from moving offshore, both transaction tax rates and tax compliance would need to be coordinated internationally. Enforcing the tax on private (off-exchange) transactions would require much more reporting than currently occurs. Similarly, no system tracks exchanges in nonregistered securities. In addition, developments in financial markets would need to be closely monitored, as there would be an incentive to devise new ways to avoid the tax, such as designing new financial instruments.
13. Doesn’t an STT have the potential to decrease the budget deficit?
Any tax has the potential to reduce the budget deficit. The question is, which taxes can raise revenue most efficiently with the fewest harmful side effects? A securities transaction tax would significantly impair the functioning of financial markets, imposing a very high cost on the economy relative to its revenues.
Claimed Benefits of a Securities Transaction Tax1
14. In addition to revenues for the federal government, what benefits do backers expect from STTs?
Backers of a securities transaction tax claim several additional benefits, including:
- Less volatility: The Economic Policy Institute recently wrote that “the current upheaval in global financial markets has…given credence to the ‘noise trader’ approach, which argues that financial markets are prone to speculation, herd behavior, and excess volatility.” In a recent paper on STTs, Dean Baker, Codirector of the Center for Economic and Policy Research (CEPR), argues: “If there are substantial numbers of noise traders (traders who act based on market movements rather than an assessment of fundamentals) in the market, the reduction in trading volume induced by a transaction tax could actually reduce volatility since it can prevent price swings driven by momentum rather than fundamentals.”
- More long-term focus by investors: A September 2009 Aspen Institute paper argued that “the focus of some short-term investors on quarterly earnings and other short-term metrics can harm the interests of shareholders seeking long-term growth and sustainable earnings, if managers and boards pursue strategies simply to satisfy those short-term investors. This, in turn, may put a corporation’s future at risk.” The report goes on to recommend “implementing an excise tax in ways that are designed to discourage excessive share trading and encourage longer-term share ownership.”
- Less financial engineering: In an April 2009 editorial, CEPR’s Dean Baker writes, “The financial engineers who specialize in constructing complex financial instruments may find an FTT financial transaction tax to be a nuisance. An FTT could cause their derivative instruments to be taxed at several points. For example, the trade of an option on a stock would be taxed, as would the purchase of the stock itself if the option was exercised. More complex derivatives could be subject to the tax many times over, substantially reducing the potential profits from complexity.”
These hypotheses are premised on several beliefs regarding investor behavior held by proponents of the tax. We believe these assumptions are incorrect.
15. Will an STT reduce stock market volatility?
There is no evidence that imposing a transaction tax reduces stock price volatility.
To date, no studies have presented evidence of decreased stock price volatility in countries that implemented or increased STTs. For example, using data from 23 countries from 1987 to 1989, Roll (1989) found that stock return volatility was not related to transaction taxes.2 Looking at price volatility in Sweden before and after imposition of transaction tax in 1984, Umlauf (1993) found that price volatility did not decline.3 Saporta and Kan (1997) found that the United Kingdom’s stamp duty did not affect volatility of securities’ prices.4 Examining the effect of allowing negotiated commission in the United States in 1975, Jones and Seguin (1997) found no evidence that lowering commissions increased volatility.5 Looking at the effect of changes in transaction taxes in Hong Kong, Japan, Korea, and Taiwan from 1975 to 1994, Hu (1998) found no significant effects on price volatility.6 Examining smaller market segments, Habermeier and Kirilenko (2001) found that transaction taxes have negative effects on price discovery, volatility, and liquidity and lead to a reduction in market efficiency.7
The expectation that stock price volatility will decline is founded on the assumption that short-term investors trade based on speculation (i.e., they are “noise traders”), whereas long-term investors trade based on the fundamental value of stock. There is no reason to believe this is a valid distinction. Short-term trades can be based on new information that alters market participants’ estimates of the long-term fundamental value of a stock. Conversely, long-term trades can be speculative in nature, betting that the fundamental value of a firm will grow over time.
16. Will an STT cause investors to take more of a long-term view?
No. That expectation is based on a misunderstanding of investor and market behavior.
The expectation that shareholders will become more patient is based on the belief that the market punishes corporations that undertake long-term investments. In practice, while the majority of stock trades are short-term, the stock market tends to reward corporations that undertake long-term investments. On average, announcements of long-term investments lead to an increase in a firm’s stock prices,8 particularly at firms that have valuable investment opportunities.9
17. Will an STT reduce financial engineering?
An STT may reduce some types of financial engineering, but it could also create new incentives to create complex financial instruments.
Engineered products that focus on short-term gains or require multiple trades in securities subject to the tax would be negatively affected by an STT. But much of what is referred to as financial engineering is not motivated by short-term gains, nor is it executed with multiple trades. A fair amount of financial engineering is undertaken in response to government policies—for example, creating securities that are treated as equity for accounting or regulatory purposes, but are treated as debt for tax purposes. As detailed in Question 21, imposition of an STT could actually increase financial engineering, as Wall Street devises methods to avoid the tax.
18. Would an STT reduce high-frequency trading and thus help financial markets?
An STT would probably discourage high-frequency trading, but it is a very blunt instrument to use in reaching that goal. Any broad-based tax on securities transactions would have negative consequences for all investors.
Furthermore, the question of whether high-frequency trading harms or helps markets is not at all settled. High-frequency trading may, at times, benefit the markets by contributing liquidity and tightening bid-ask spreads. At the same time, high-frequency trading raises a number of regulatory issues that should be examined closely. That is why ICI supports the Securities and Exchange Commission’s (SEC’s) current broad examination of market structure issues, including high-frequency trading.
Proposed Securities Transaction Tax Legislation, H.R. 3313
19. What sorts of STTs have been proposed recently?
The most recent legislative proposal for an STT in the United States is H.R. 3313, titled “Wall Street Trading and Speculators Tax Act.” It was introduced in the House of Representatives on November 2, 2011, by Representative Peter DeFazio (D-OR). Senator Tom Harkin (D-IA) has introduced similar legislation (S. 1787) in the Senate.
20. How would H.R. 3313 work?
H.R. 3313 would apply a 3-basis-point (0.03 percent) tax on the purchase of a security.
Securities are defined to include stocks, partnership interests, notes, bonds, debentures, or other evidence of indebtedness, and interests in derivative financial instruments, such as options, futures, and swaps. In the case of stocks, partnership interests, and debt, the base of the tax is the fair market value of the security. In the case derivatives, the basis for the tax is the cash flow generated by the contract, with each payment considered a separate transaction.
The tax would apply to all purchases and sales that occur in the United States on a trading facility or to any transaction where either the purchaser or seller is a U.S. person. The tax would not apply to initial issuance, debt with a fixed maturity 100 days or less, and securities lending arrangements.
Because the bill exempts the “initial issuance” of shares, the purchase of shares from the mutual fund itself should not be subject to tax; redemptions of shares would be taxed.
21. What impact would the securities transaction tax proposed in H.R. 3313 have on investors?
Like any other STT, the proposed tax in H.R. 3313 would impair the functioning of the financial markets. The proposed tax would reduce volume and liquidity in stock and fixed-income markets, resulting in wider bid-ask spreads, to the detriment of all investors. Any such tax would raise taxes on middle-class investors, depress the value of financial assets, and increase the cost of hedging risk.
Specifically, H.R. 3313 would hurt the 92 million investors in registered investment companies (mutual funds, ETFs, closed-end funds, and unit investment trusts) by reducing their investment returns (see Question 6 above).
History of Securities Transaction Taxes in the United States
22. Are there any STTs currently in place in the United States?
Currently, the SEC imposes a “Section 31 fee” on stock transactions, and the proceeds of this STT are used to fund the agency. As of April 1, 2012, that tax was 0.224 basis points (0.00224 percent).
23. How does the proposed STT in H.R. 3313 compare to the Section 31 transaction tax?
The proposed 3-basis-point (0.03 percent) transaction tax rate is more than 10 times the current Section 31 rate.
24. Does the United States have a history of securities transaction taxes?
From 1914 to 1965, the federal government did impose a securities transaction tax. This STT was initially 2 basis points (0.02 percent) in 1914, increased to a range of between 4 and 6 basis points from 1932 through 1958, and reverted to 4 basis points from 1959 until the tax was repealed in 1965.
25. What is the difference between the STT proposed in H.R. 3313 and the STT imposed in the United States between 1914 and 1965?
H.R. 3313 would apply to a wide range of securities transactions whereas the earlier tax was only imposed on stock transfers.
Another difference is that from 1914 through 1958, the historical STT was assessed on the par value of stock. H.R. 3313 would instead apply the tax to the stock’s market value of a stock, instead of the par value of the stock. Par value is a legal concept that bears no relation to market value. A stock’s par value is typically less than its market value.
In 1959, the tax was applied to the market value of a transferred stock, increasing the tax base. It is only at this point that the historical STT became more directly comparable to the tax proposed in H.R. 3313. However, in 1965, only six years later, Congress viewed the tax as complicating securities transactions and repealed it.
26. Would it be reasonable to assume that the tax proposed in H.R. 3313 would have an impact on financial markets similar to the effect that the historical STT had on the markets between 1959 and 1965?
No. An STT of any given magnitude would have a far greater impact on investor returns today than historically. Overall transaction costs have declined markedly since 1965, so a tax would represent a much greater increase in costs, proportionately.
Securities Transactions Taxes in the United Kingdom and Sweden
27. Isn’t there a securities transaction tax in the United Kingdom?
Yes. The United Kingdom has a stamp duty. The tax rate is 50 basis points, or 0.5 percent.
28. What are the differences between the STT proposed in H.R. 3313 and the UK stamp duty?
There are two main differences between the UK tax and the one proposed in H.R. 3313, both of which make the proposed U.S. tax more sweeping.
First, the U.S. proposal taxes all securities purchases, including those made by intermediaries such as dealers. By contrast, UK tax law exempts intermediaries from the tax on securities purchases. This is a significant difference because intermediaries facilitate many stock exchange trades.
Typically, one long-term investor does not sell a block of shares to another long-term investor looking to buy the same number of shares. Instead, investors usually trade through market makers, dealers, or other intermediaries, who provide liquidity by constantly buying and selling shares on the market and from their own inventory. Under the UK stamp duty, intermediaries are exempt from tax, so such trades are taxed only once, when an investor buys shares from an intermediary and pays the tax. Under H.R. 3313, such trades that provide market liquidity would be taxed twice—once when an intermediary purchases the shares from an investor, and again when another investor later buys the shares from the intermediary.
Second, the tax base in H.R. 3313 is much broader, encompassing not just stocks but also partnership interest, debt, and derivative contracts. It would also tax private (off-exchange) transactions and exchanges in nonregistered securities.
29. What impact has the UK stamp tax had on market liquidity in the United Kingdom?
It is noteworthy that the UK stock market is much less liquid than the U.S. stock market. According to figures presented by Gus Sauter, chief investment officer of the Vanguard Group,10 in 2009, average daily turnover in the UK stock market was 0.37 percent—approximately one-fourth the 1.38 percent average daily turnover in the U.S. stock market. Moreover, turnover in the UK market would likely be even lower if liquidity-providing intermediaries were subject to the tax, as they would be under H.R. 3313.
30. What effect has the UK stamp tax had on securities trading in the United Kingdom?
The stamp tax has caused much of the trading in the United Kingdom to migrate to securities that are exempt from the tax, with several results:
- Trading in equities in the United Kingdom has declined, while trading in options and derivatives—which are not subject to the UK tax—has increased.11
- UK investors are increasingly trading American Depository Receipts (ADRs) of UK firms rather than trading shares of the firms on the London exchange.12
- In the UK market, investors are increasingly opting to use Contracts for Differences (CFDs), which are derivatives transactions, to avoid the transaction tax.13
31. Did Sweden have a securities transaction tax?
Yes. The tax was introduced in January 1984. Both purchases and sales of domestic equities were taxed at 0.5 percent (50 basis points) for a combined 1 percent tax on each transaction. Trading in stock options was also taxed. In July 1986, the tax rate was doubled. In 1989, the tax was extended to trading in fixed-income securities and derivatives, but at lower rates than those applied to stock trades.
32. What were the effects on stock trading from Sweden’s STT?
After Sweden doubled the transaction tax rate in 1986, Umlauf (1993) found that 60 percent of the volume of the 11 most actively traded Swedish stocks migrated to London.14 That shift represented 30 percent of all trading volume in Swedish equities. By 1990, 50 percent of all trading in Swedish equities had migrated.
In a separate study, Campbell and Froot (1995) found that only 27 percent of the trading volume in Ericsson, a major company based in Sweden, took place on the Stockholm exchange in 1988.15
Umlauf also looked at stock price volatility in Sweden before and after imposition of the transaction tax in 1984, and he found that price volatility did not decline.
33. Does Sweden still have a securities transaction tax?
No. Sweden began phasing out the tax in 1990 and abolished it in December 1991.
1 This discussion of the empirical evidence on the effects of a transaction tax on financial markets was written in early 2010. Two recent studies look at the empirical evidence and reach conclusions very similar to those presented below, particularly regarding the potential of an STT to reduce stock market volatility. See Thornton Matheson, 2011, “Taxing Financial Transactions: Issues and Evidence,” IMF Working Paper WP/11/54. See also Neil McCulloch and Graxia Pacillo, 2011, “The Tobin Tax—A Review of the Evidence,” Institute of Development Studies Research Report, 68. For an additional discussion of the likely impact of a transaction tax on the functioning of the financial markets, see Congressional Budget Office, 2011, “Response to Questions About the Effects of a Tax on Financial Transactions That Would Be Imposed by the Wall Street Trading and Speculators Tax,” December 12. Available online at www.cbo.gov/ftpdocs/125xx/doc12576/12-12-2011_Hatch_Letter.pdf.
2 Richard Roll, 1989, “Price Volatility, International Market Links, and Their Implications for Regulatory Policies,” Journal of Financial Services Research 3, 211–246.
3 Steven R. Umlauf, 1993, “Transaction Taxes and the Behavior of the Swedish Stock Market,” Journal of Financial Economics 33, 227–240.
4 Victoria Saporta and Kahmhon Kan, 1997, “The Effects of Stamp Duty on the Level and Volatility of UK Equity Prices,” Working Paper, Bank of England.
5 Charles M. Jones and Paul J. Sequin, 1997, “Transaction Costs and Price Volatility: Evidence from Commission Deregulation,” American Economic Review 87, 728–737.
6 Shing-yang Hu, 1998, “The Effects of the Stock Transaction Tax on the Stock Market—Experiences from Asian Markets,” Pacific-Basin Finance Journal 6, 347–364.
7 Karl Habermeier and Andrei Kirilenko, 2001, “Securities Transaction Taxes and Financial Markets,” IMF Working Paper.
8 Donald W. Kiefer, 1990, “The Securities Transactions Tax: an Overview of the Issues,” CRS Report for Congress, July 25.
9 Kee H. Chung, Peter Wright, and Charlie Charoenwong, 1998, “Investment Opportunities and Market Reaction to Capital Expenditure Decisions,” Journal of Banking and Finance 22.
10 “Financial Transactions Tax: Taxing U.S. Investment, Savings, and Growth,” December 16, 2009, www.uschamber.com/webcasts/2009/091216_ccmc_ftt.htm (video) at 16:45 minutes.
11 Government of Canada, Depository Services Program, 1996, Financial Transactions Taxes: The International Experience and the Lessons for Canada. Available at http://dsp-psd.pwgsc.gc.ca/Collection-R/LoPBdP/BP/bp419-e.htm.
13 EU Clearing and Settlement Fiscal compliance Experts’ Group, 2006, Fact-Finding Study on Fiscal Compliance Procedures Related to Clearing and Settlement Within the EU. Available at http://ec.europa.eu/internal_market/financial-markets/docs/compliance/ff_study_en.pdf.
14 Umlauf 1993.
15 John Y. Campbell and Kenneth A. Froot, 1995, “Securities Transaction Taxes: What About International Experiences and Migrating Markets,” Securities Transaction Taxes: False Hopes and Unintended Consequences, Catalyst Institute.