Taxing Transactions in Financial Derivatives: Problems and Solutions
The Case for Taxing Derivatives
In September 2014, as eleven European nations moved closer to agreeing upon a Financial Transactions Tax that included derivatives, Professor Avinash Persaud published a definitive report dismantling the banking lobby's primary arguments against the policy. The report outlined practical, legally enforceable solutions to ensure that a tax on derivative instruments would be highly effective, impossible to rationally evade, and capable of generating billions in new revenue.
Persaud highlighted that stamp duties on legal transactions are among the oldest and least avoided taxes in existence, with the United Kingdom successfully operating such a tax since 1694. In the modern era, more than thirty countries collectively raise over thirty billion dollars every year through stamp duties on financial transactions, proving their undeniable feasibility. The United Kingdom alone collected over six billion euros annually from its share transaction tax prior to granting additional exemptions in 2013. Because the transfer of legal title is entirely dependent on the tax being paid, evasion is practically non-existent, resulting in up to sixty per cent of the United Kingdom tax being paid by non-residents.
The Residence Principle and Legal Enforceability
The financial sector frequently argued that taxing derivatives is impossible because, unlike traditional shares with a single registry of ownership, derivative contracts can be issued from any jurisdiction. Consequently, the traditional issuance principle used for standard equities cannot reliably capture derivative trades. However, the report proposed a robust solution by advocating for the residence principle. Under this framework, the tax becomes due irrespective of where the transaction is executed, provided that one of the counterparties, or the beneficial owner of a counterparty, resides within a participating tax jurisdiction.
To guarantee compliance and prevent traders from routing their transactions offshore, the report recommended making any derivative instrument upon which the tax is unpaid legally null and void within the participating jurisdictions. Because derivative contracts are essentially zero-sum games, the winning party demands absolute legal enforceability to secure their payout. Standard International Swaps and Derivatives Association contracts could simply be amended to trigger automatic tax payments, thereby ensuring that no rational financial institution would risk holding an unenforceable, untaxed asset.
The End of Offshore Evasion
The banking sector's threat to relocate derivative operations to tax havens was exposed as an outdated bluff. Following the global financial crisis and the tightening of anti-terrorist financing laws, international regulatory frameworks have been drastically strengthened. Global initiatives such as the United States Foreign Account Tax Compliance Act and the European Market Infrastructure Regulation require mandatory reporting and central clearing for all standard derivative products. Simultaneously, global anti-money laundering forces have made it exceedingly difficult to establish anonymous shell companies, meaning traders can no longer hide their beneficial ownership to evade residency-based taxes.
Structuring the Tax Rate
To prevent market distortion, the report advised that the tax rate must be modest compared to existing transaction costs. While the financial industry attempts to present transaction costs purely as tiny bid-ask spreads, actual costs including clearing, settlement, and brokerage fees range between one and one and a half per cent of assets under management per annum for long-term investors. The proposed tax rates of a fraction of a per cent are minuscule in comparison.
For derivatives, the tax could be set at 0.1 per cent of the premium and cash settlement, or it could simply match one hundred per cent of existing clearing house fees. Furthermore, the tax structure should actively penalise systemically dangerous activity by levying a two hundred per cent rate on instruments that bypass central clearing.
Protecting Pensioners and Targeting Speculation
The report concluded by firmly advising against granting exemptions to pension funds. Because pension funds are long-term investors that turn over their portfolios infrequently, their effective annual tax burden would be a negligible fraction of their total costs. Conversely, high-frequency traders turning over their entire portfolios multiple times a day would face immense tax liabilities, thereby driving this destabilising, speculative activity out of the market. Only tightly defined market makers should receive exemptions, ensuring that the tax falls squarely on aggressive short-term speculation rather than genuine investment.
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