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Dr. William Barclay Chicago Political Economy Group Testimony to Illinois Legislative Pension Committee Hearing July 8, 2013 Worked 22 years at Chicago exchanges ◦ MidAmerica Commodity Exchange, CBOT, CBOE and Chicago Stock Exchange ◦ Responsibilities included: Product development Strategic planning Market research ◦ Worked with: Exchange staff Members (individual and institutions) Regulators: CFTC and SEC ◦ Occasional trader of derivative products Founding member Chicago Political Economy Group (CPEG) Dr. William Barclay, CPEG 7/8/2013 2 Financial Transaction Tax What do Switzerland, Australia, Hong Kong and Singapore have in common? ◦ They are all ranked in the top 5 countries on the Heritage Foundation’s “Index of Economic Freedom.” ◦ They also all have a financial transaction tax (FTT). FTTs are, therefore: ◦ Not an unusual tax. ◦ Not a threat to successful financial markets. Keynes, James Tobin and Larry Summers have all advocated FTTs – as did Pope Benedict XVI. Dr. William Barclay, CPEG 7/8/2013 4 Country Rate Products Covered Austria 0.15% Stocks and bonds Australia 0.3% and 0.6% Stocks and bonds Brazil 5.2% Short term forex trades India 0.25% and 0.02% Stocks, options and futures Taiwan 0.3%, 0.1%, 0.1% Stocks, bonds and futures 11 European countries (France, Germany, Italy, Spain, etc.) 0.1% - Jan 2014 Stocks and some derivatives Dr. William Barclay, CPEG 7/8/2013 5 HR1554 sponsored by Rep. Mary Flowers would impose a Financial Transactions Tax on buyers and sellers equal to: ◦ 0.01% of the underlying or notional value of contracts traded on the CME(including the CBOT) and the CBOE – 1 cent per $100 of underlying value 2012 notional value on the CME alone was $805 trillion. ◦ The tax would be imposed on stock, futures, swap, credit default swap, and options contracts. ◦ It would not include transactions involving securities held in retirement or mutual fund accounts. ◦ The rate proposed in HR 1554 (1 basis point) is much less than commonly found among markets with FTTs. Assuming even a 50% decline in trading, it would raise $30 – 40 billion annually. Dr. William Barclay, CPEG 7/8/2013 6 An FTT on derivative contracts traded on Chicago derivative exchanges (CME* and CBOE) Derivatives have both a buyer and a seller Both would pay the $1/contract FTT Even on the smallest contracts, this $1 is de minimus when compared to the underlying or notional value of the contract ◦ E.g., Corn futures – roughly a $30,000 contract A $1 FTT would be less than 0.0033% of contract value (1/3rd of a basis point) ◦ On larger contracts a dollar would represent even less, e.g., on the Eurodollar futures, a $1 fee on a $1,000,000 contract (0.00010% ) * CME owns the Chicago Board of Trade Dr. William Barclay, CPEG 7/8/2013 7 Chicago Board Options Exchange (CBOE): ◦ Stock index options (on S&P 500, Dow, NASDAQ, etc); Exclude options on individual stocks (size and competition) Chicago Mercantile Exchange (CME) ◦ Stock index futures and futures options (S&P 500, Dow, NASDAQ, etc.) ◦ Futures and futures options on interest rates products (T-bonds, T-Notes, Eurodollars, etc.) ◦ Futures and futures options on currencies (Euro, UK pound, yen, etc.). ◦ Futures and futures options on commodities (corn, wheat, soybeans, hogs, cattle, etc.) Dr. William Barclay, CPEG 7/8/2013 8 Total Revenue $7.00 US $ Billions $6.00 $5.00 $4.00 $6.6 $6.1 $3.00 $6.1 $5.2 $4.6 Total Revenue $2.00 $1.00 $0.00 2008 2009 2010 2011 2012 Dr. William Barclay, CPEG 7/8/2013 9 The most common one is: “The exchanges will move out of state.” Another common one is: “Traders will take their business elsewhere.” Yet another one is: “The tax could be easily evaded and/or costly to collect.” Let’s consider each in turn by looking at the economic arithmetic of an FTT (the incentives involved). Dr. William Barclay, CPEG 7/8/2013 10 The relevant question: Have exchanges moved when FTTs were implemented? No – this has not occurred. Why? The tax is not paid by the exchange. There is no economic incentive for the exchange to move. ◦ An FTT is levied on the act of trading. The exchange simply functions as the collection agency for an FTT. Dr. William Barclay, CPEG 7/8/2013 11 Consider 3 very active futures contracts: Corn: E-Mini S&P 500: 10 Year T-Note: A $1/contract FTT is less than the minimum tick. ◦ Each contract is for 5000 bushels ◦ Smallest price change (minimum tick) is $0.0025 = $12.50 ◦ Each contract is $50 x the index (about $81,000 today) ◦ Minimum tick (smallest price change) is .25 index points = $12.50 ◦ Each contract of for $100,000 face value ◦ Minimum tick is 1/64 of a point = $15.625 Dr. William Barclay, CPEG 7/8/2013 12 Consider this economic arithmetic from the perspective of a trader (hedger, e.g., farmer, portfolio manager) or a speculator: If the $1/contract FTT was levied, the trader would give up a fraction of the smallest first and last price change: ◦ $1 of $6.25, $12.50 or $15.625 ($25 on the big S&P 500 Index futures) ◦ What kind of trading strategy or trader is looking for price changes less than the smallest amount a contract can change in value? Another way of thinking about this: The $1/contract FTT is significantly less than the difference between the bid and ask prices for these contracts. The economic incentive for a trader to move is very limited. Dr. William Barclay, CPEG 7/8/2013 13 The relevant question: To where would traders go? Some products trade under exclusive licenses. ◦ These include almost all stock index products. Derivative exchange competition is not primarily product based. ◦ Very few identical products are listed on different derivative exchanges. ◦ This may reflect 1980s/early 1990s competition in FX and petroleum products. Consistent outcome: one exchange won all the volume. It also reflects the problem of liquidity creation in derivatives trading. Dr. William Barclay, CPEG 7/8/2013 14 The argument that an FTT would be easy to evade/costly to administer also has little merit. Clearing houses match and clear all trades (CME’s Clearing House and OCC for CBOE). The CH already serves as a collection agency for transaction fees. The CH could easily collect an FTT. Thus an FTT is very low cost to administer and difficult to evade. Dr. William Barclay, CPEG 7/8/2013 15 The FFT is on the act of trading – like a sales tax for buying clothes, food, a car, etc. ◦ It is on both buying and selling the derivative. The FFT is a very progressive tax because of who trades and thus who would pay the tax : ◦ Institutions such as banks, hedge funds, brokerdealers ◦ High-income individuals ◦ Day traders Dr. William Barclay, CPEG 7/8/2013 16 What is good tax policy: ◦ A good tax should be a small amount for any single event. ◦ A good tax should fall on those able to bear the tax. ◦ A good tax should tax activity that we want to limit or discourage. Lord Adair Turner – much of what goes on in finance is “socially useless” activity. ◦ A good tax should further economic or social justice. Dr. William Barclay, CPEG 7/8/2013 17 A $1/contract FTT meets the criteria for a good tax: ◦ The FFT rate is very low compared to the value of a contract. Total notional value of trading on the CME in 2012 was $806 trillion. ◦ The FFT would fall primarily on high income individuals and wealthy institutions. ◦ The FFT would probably discourage some “socially useless” short term trading. ◦ An FFT taxes the sector that caused the financial crisis that led to the Great Recession. Dr. William Barclay, CPEG 7/8/2013 18 “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” - John Maynard Keynes Dr. William Barclay, CPEG 7/8/2013 19 Raising Revenue from Those Who Can Afford It Some claim Illinois is a high tax state. That depends on where your household falls in the income continuum. Consider all major taxes: income, property and sales taxes. ◦ IL bottom quintile households pay taxes at the 2nd highest rate in the US. ◦ Middle income quintile households pay taxes at the 5th highest rate in the US. ◦ However, top 1% income households pay taxes at the only the 30th highest rate in the US. ◦ The next 4% of households by income pay taxes at only the 15th highest rate in the US. A graduated income tax would help remedy this unfair distribution of taxation. Dr. William Barclay, CPEG 7/8/2013 21 CTBA’s GIT proposal would: ◦ Raise $2.4 - $3.4 revenue annually. ◦ Cut overall state income tax burden for 94% of all taxpayers. Taxpayers with under $150,000 in annual base income would receive a tax cut. Effective rates would be 0% for incomes below $9,000 and slowly increase to roughly 6%. ◦ Keep the effective state income tax rate for millionaires. ◦ Stimulate the growth of at least 36,000 jobs in the state’s private sector through enhanced public and consumer spending. Dr. William Barclay, CPEG 7/8/2013 22 34 of the 41 states with individual income taxes have graduated rates. Iowa’s GIT applied to Illinois would raise 42% more revenue than the roughly $15 B raised from Illinois’ current temporary 5% flat rate ◦ It would still cut rates for most filers. KY, MO, and WI all have GIT’s that raise 11% to 24 % more revenue and cut tax rates for most filers. If Illinois had Oregon’s GIT, the state would almost double its IIT revenue. Dr. William Barclay, CPEG 7/8/2013 23 A Summary of Dr. Ron Baiman’s July 3, 2013, Testimony CME’s tax reduction - $85 million Foreign dividend exclusion - $386 million Domestic production credit - $200 million ◦ IL would join 22 other states in decoupling On line hotel room purchases - $25 million Offshore oil drilling - $75 million ◦ Many other states tax the income share that can be apportioned to their state Retailer’s discount - $109 million ◦ Flows largely to out-of-state retail chains such as WalMart TOTAL: $880 million/year in lost tax revenue Dr. William Barclay, CPEG 7/8/2013 25 Allocate the $880 million to a dedicated fund. Use the same CFGA* return and investment assumptions that underlie the $95 billion “pension shortfall.” Use CFGA same 33 year period. Net present value of these 6 tax loopholes: $70.5 billion *Commission on Government Forecasting and Accountability Dr. William Barclay, CPEG 7/8/2013 26 Illinois has potential revenue sources. Illinois can enact legislation that would: ◦ Solve the “pension funding crisis.” ◦ Not take away from teachers, state employees, and others their earned benefits. ◦ Pass constitutional scrutiny. An FTT is a particularly attractive path. It is time to act. Dr. William Barclay, CPEG 7/8/2013 27 Dr. William Barclay, CPEG 7/8/2013 28