The Effects of a Financial Transaction Tax on European Households Savings SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION

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1 The Effects of a Financial Transaction Tax on European Households Savings SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION

2 The Effects of a Financial Transaction Tax on European Households Savings SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION

3 The effects of a financial transaction tax on European households savings was prepared for the International Regulatory Strategy Group (IRSG) and is published by the City of London. The author of this report is London Economics. February 2014 City of London PO Box 270, Guildhall London EC2P 2EJ This publication does not constitute an opinion and has been written in general terms for discussion only and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication. London Economics as author, and the International Regulatory Strategy Group, City of London and TheCityUK as publisher, give no warranty as to the accuracy and completeness of the material, and accept no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication. The International Regulatory Strategy group (IRSG) is a practitioner led body comprising leading UK-based figures from the financial and professional services industry. It aims to contribute to the shaping of the international regulatory regime, at global, regional and national levels, so that it promotes open, competitive and fair capital markets globally that support sustainable economic growth. Its role includes identifying strategic level issues where a cross sectoral position can add value to the existing industry views. It is an advisory body both to the City of London Corporation and to TheCityUK, an independent practitioner led body which has been established to coordinate the promotion of the UK based financial services industry.

4 Executive summary 1 1 Introduction Household savings in equity andd debt Geographic breakdown Asset class breakdown Cascade and the effective tax rate Structure of the reportt Expected FTT impacts the issuance principle Equity holdings Overview of households holdings Methodology Results Short-term debt holdings Overview of households holdings Methodology Results Long-term debt holdings Overview of households long-term debt holdings Methodology Results Overview of key results Expected FTT impacts the residence principle Key assumptions Equity holdings Overview of households affected holdings Methodology Results Short-term debt holdings Overview of households affected holdings Methodology Results Long-term debt holdings Overview of households affected holdings Methodology... 27

5 Results Overview of key results Summary of results and conclusion Total impact of the FTTT Summary of findings Immediate and long-term impacts on savingss Macroeconomic impactt Conclusionss Appendix 1 - Household statistics by country... 36

6 Executive summary This study considers the impact of the proposed financial transaction tax (FTT) on European households savings arising through its effect on the value of equity and debt holdings. The effect of the tax is considered in six EU Member States. Four of these countries are planning to participate in the FTT (Germany, Italy, Spain and Slovakia) and two are not (Luxembourg and United Kingdom). The selection of countries aimed to capture a mix of larger and smaller Member States, Member States in different parts of Europe and, in turn, different rates of savings through equity and debt. The EU proposal for an FTT of 14 February 2013 covers a broad range of financial instruments, including debt and equity, and if introduced, the tax would be applicable to secondary market transactions involving financial institutions from participating Member States (the residence principle) and instruments issued in participating Member States (the issuance principle) at a rate of 0.1% of the value of equities and bonds. Context Financial assets are an important instrument for saving for European households, providing them with access to emergency funds and allowing them to build future retirement income. When deciding how to save, households face a choice between financial and real assets (such as housing). In the euro area as a whole, 17% of household savings are held directly in financial assets. However, this figure masks considerable variation across countries: for instance, in Slovakia the proportion is 8%, compared to around 36% for Germany. 1 Households hold various types of financial assets. In the UK for instance, life insurance and pension funds are highly important instruments for savings, as they make up over half of total financial savings. Meanwhile, in Italy, there is a high level of direct investment in financial markets, with 40% of household savings being held directly in the form of equity or debt; this figure is 23% in Spain. By age, holdings of financial assets show very clear life-cycle behaviour in many countries: financial savings increase up to 64 years of age (as a primary motive for financial saving is providing funds for retirement) after which they fall (as older people drawdown on these funds during retirement). 2 These findings indicate that households participate in financial markets; that household participation takes a variety of forms; and, among other reasons, that saving through financial assets is an important means of retirement provisioning. Given this, the functioning of capital markets through which households save is of significant policy interest. 1 Data sourced from ECB (2013), The Eurosystem Household Finance and Consumption Survey: Results from the First Wave. Statistics Paper Series No. 2, April Data sourced from ECB (2013), The Eurosystem Household Finance and Consumption Survey: Results from the First Wave. Statistics Paper Series No. 2, April

7 The proposed financial transaction tax and household savings This study considers the impact of the proposed financial transaction tax on European households savings. Data on household savings and trading activity used for the analysis are available as at the end of The estimates therefore reflect what the impact of the proposed FTT would be if it were in place then without any behavioural effects resulting from the introduction of the tax. In particular, the effect considered is the instantaneous price adjustment resulting from the introduction of the tax: If the FTT is introduced, its expected costs would be capitalised into the price of assets subject to the tax and the price adjustment would take place practically instantaneously, thereby affecting the value of household equity and debt holdings. There exists a significant body of empirical evidence supporting the existence of instantaneous price adjustments Methodology Data from two information sources were used to construct the financial portfolios: Data on the household financial portfolios of domestically and foreign issued equity and debt holdings, available from Eurostat; 8 Data on the distribution of household and country-wide financial portfolios in equity and debt across many issuing countries, available from the IMF Coordinated Portfolio Investment Survey (CPIS). 9 The latter information was used to split the foreign component of the Eurostat equity and debt portfolio into a portfolio of holdings from FTT-participating countries (other than the home country if the latter is a participating country) and FTT nonparticipating countries. Data on trading frequencies used for the calculations of the impact of the FTT were drawn from two sources also. For equities, the actual 2011 turnover rate (i.e. annual turnover/average market capitalisation during the year) 10 was used and sourced either from the annual statistics published by Federation of European Securities Exchanges (FESE) or from the statistics produced by the various stock exchanges. For debt, inter alia trading data provided by Tradeweb 11 were used. 3 Jackson, P.D. and O Donnell, A.T. (1985). The effects of stamp duty on equity transactions and prices in the UK stock exchange, Bank of England Discussion Paper, No Umlauf, S. (1993). Transaction taxes and the behaviour of the Swedish stock market, Journal of Financial Economics, 33, pp Saporta, V. and Kan, K. (1997). The effects of stamp duty on the level of volatility of UK equity prices, Bank of England Working Paper No Oxera (2007) Stamp duty: its impact and the benefits of its abolition, Report prepared for the ABI, City of London Corporation, IMA and London Stock Exchange, May. 7 Best, M.C. and Kleven, H.J. (2013) Housing market responses to transaction taxes: evidence from notches and stimulus in the UK. Mimeo. 8 See Eurostat, European sector accounts, 9 The IMF data is available at 10 The information was sourced either from the annual statistics published by FESE or from the statistics produced by the various stock exchanges. 11 Builds and operates electronic fixed income and derivatives marketplaces for institutional investors. 2

8 Summary of main findings The results of the analysis show that the impact of the FTT on household savings is expected to be large in some Member States. In countries that plan to introduce the tax for example, the impact is in the order of 80 billion (Spain) to 205 billion (Italy), representing a loss of up to 16% of the value of the assets being taxed. Household savings are expected to be less affected by the FTT in other Member States: in non-participating states such as Luxembourg and the United Kingdom; and in participating Member States such as Slovakia. Figure 1: Total impact of the FTT on household savings in equity and debt holdings Reduction in the value of equity and debt holdings Participating Member States Note: 1 Impact scaled as a percentage of GDP, not impacting GDP directly. What are the reasons for differences across Member States? The larger the expected costs of the tax, the larger the loss in value of household savings. Expected costs are larger: (i) the more frequently asset transactions subject to the tax take place (a trading frequency effect); and (ii) the larger the number of intermediate transactions required to transfer the asset between end-investors in transactions subject to the tax (a cascade effect). The expected impact is larger for households in participating than in nonparticipating Member States. This is because households in non-participating Member States are less likely to have their transactions taxed under the issuance principle (that is, domestically issued equities and debt are not subject to the FTT under the issuance principle). bn Percentage of equity and debt holdings Percentage of GDP 1 Germany % -5.8% Italy % -13.0% Spain % -7.6% Slovakia % -0.1% Non-participating Member States United Kingdom % -0.2% Luxembourg % -0.9% 3

9 The expected impact of the FTT on household savings also depends on the mix of equity and debt assets households own. With the exception of government debt, equities tend to be traded more frequently than debt meaning that households that hold relatively more equity than debt are likely to suffer greater losses to the value of their savings if the tax is introduced the trading frequency effect is more significant for these households. Equally, assets issued in different countries change hands at different rates so households holding assets issued in countries where assets are traded more frequently are also likely to suffer greater losses in the value of their savings. The results presented account for all of the considerations described and Figure 2 provides a breakdown of the total impact of the FTT shown above by security type. Figure 2: Breakdown of impact of the FTT on household savings in equity and debt holdings, by asset class Participating Member States Total ( bn) Equity ( bn) Debt ( bn) Germany Italy Spain Slovakia ** Non-participating Member States United Kingdom ** Luxembourg ** Note: **smaller than The cascade effect The inclusion of intermediaries within the scope of the FTT significantly increases the tax incidence, creating a cascade effect. In particular, it is typical for the transfer of an equity or bond between end-investors to attract ten instances of the tax, equivalent to 100bps Indeed, the impact on the value of savings is significantly reduced when the effective tax rate is only 20 basis points, i.e., all the financial intermediaries in the trading chain are exempt from the tax. For example, the loss in the value of savings is reduced to 3-4% of the value of the initial equity and debt holdings in the case of Germany, Italy and Spain. 12 For debt see also London Economics (2013), The Impact of a Financial Transaction Tax on Corporate and Sovereign Debt, Report prepared for the International Regulatory Strategy Group (IRSG), TheCityUK and City of London, April. 13 For equities see Clifford Chance (2013), Financial Transactions Tax: Update, available at: e.html 4

10 Figure 3: Comparison of the overall impact on the value of savings of a 100 bps and 20 bps effective FTT Reduction in the value of equity and debt holdings (%) 100bps 20bps Participating Member States Germany -14.1% -3.6% Italy -12.3% -3.1% Spain -16.0% -4.0% Slovakia -2.3% -0.5% Non-participating Member States United Kingdom -0.6% -0.1% Luxembourg -2.2% -0.5% Immediate impact on savings The immediate loss in the value of household savings expected as a result of the introduction of the FTT is a multiple of annual household savings in some Member States. If the tax were introduced in Spain for example, households would have to save for an entire year in order to restore the value of their savings to their level prior to the introduction of the tax; in Italy, they would have to save for eighteen months. Macroeconomic impacts Recent studies from the ECB and IMF show that typically, a 10% change in the value of household savings reduces aggregate household consumption by1% in the long run. 14 As consumption accounts for between 56% and 62% of GDP (except in Luxembourg), the impact on the value of savings described suggest that, all else being equal, the level of GDP (at constant prices) would be between 0.5% and 0.8% lower in the long run as a result of the impact on the value of savings arising from the proposed FTT. 14 Sousa, Ricardo (2009). Wealth Effects on Consumption, Evidence from the Euro Area. ECB Working Paper No. 1050/ May 2009; and Ludwig and Sløk (2001), Impact of Stock Prices and House Prices on Consumption in OECD Countries, IMF Working Paper No. 1. 5

11 Figure 4: Impact of the FTT on the long-run level of household consumption (at constant prices) 0.0% -0.2% -0.4% Germany Italy Spain Slovakia -0.2% United Kingdom -0.02% Luxembourg -0.1% -0.6% -0.8% -1.0% -1.2% -1.4% -1.6% -1.8% -1.4% -1.2% -1.6% Note: the estimated impact for the UK is reported to 2 decimal places because the effect is comparatively small; the estimates for other countries are reported to 1 decimal place because, due to uncertainty about the estimates, reporting them to 2 decimal places would imply a greater precision than can be interpreted from the estimates. Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio Investment Survey and Ricardo (2009) and Ludwig and Sløk (2001) Figure 5: Impact of the FTT on the long-run level of GDP (at constant prices) 0.0% -0.1% Germany Italy Spain Slovakia United Kingdom -0.01% Luxembourg -0.1% -0.2% -0.1% -0.3% -0.4% -0.5% -0.6% -0.5% -0.7% -0.8% -0.9% -0.8% -0.7% Note: the estimated impact for the UK is reported to 2 decimal places because the effect is comparatively small; the estimates for other countries are reported to 1 decimal place because, due to uncertainty about the estimates, reporting them to 2 decimal places would imply a greater precision than can be interpreted from the estimates. Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio Investment Survey and Ricardo (2009) and Ludwig and Sløk(2001) 6

12 Finally, it is important to note that this study considers the effect of the instantaneous price adjustment resulting from the introduction of the tax. In the long-term, or, on an ongoing basis, savings may also be affected. Two important considerations in this regard are as follows. Households may not respond to the loss in value of their savings by increasing their savings rate. If they do not increase their savings rate, savings may be permanently lower due to the introduction of the FTT. For example, households which invest in financial assets through a vehicle (UCITs fund, pension fund or life insurance) will see the value of their savings eroded over time as the FTT will be levied on any changes in the portfolio, which for an actively managed fund can lead to a significant cost. 15 Household incomes, and therefore savings, will also fall with the introduction of the tax through other channels. This is due to the effect the tax is expected to have on the cost of capital and in turn GDP, as discussed elsewhere (see London Economics, ). 15 EFAMA (2011) EFAMA s comments on the Commission s proposal for a Council Directive on a common system of financial transaction tax, available at

13 1 Introduction Financial assets are an important instrument for saving for European households, providing them with access to emergency funds and allowing them to build future retirement income. When deciding how to save, households face a choice between financial and real assets (such as housing). In the euro area as a whole, 17% of household savings are held in financial assets. However, this figure masks considerable variation across countries: in Slovakia the proportion is 8%, compared to around 36% for Germany. In the UK, more than half of households savings (55%) are held as financial assets. Households hold various types of financial assets. In the UK for instance, life insurance and pension funds are highly important instruments for savings, as they make up over half of total financial savings. Meanwhile, in Italy, there is a high level of direct investment in financial markets, with 40% of household savings being held directly in the form of equity or debt; this figure is 23% in Spain. By age, holdings of financial assets show very clear life-cycle behaviour in many countries: financial savings increase for age groups up to 64 years of age (as a primary motive for financial saving is providing funds for retirement) after which they fall (as older people drawdown on these funds during retirement). These findings indicate that households participate in financial markets; household participation takes a variety of forms; and, among other reasons, suggests that saving through financial assets is an important means of retirement provisioning. Given this, the functioning of capital markets through which households save is of significant policy interest. The EU proposal for a financial transactions tax (FTT) covers a broad range of financial instruments and, if introduced, the tax would be applicable to secondary market transactions involving financial institutions from participating Member States (the residence principle) and instruments issued in participating Member States (the issuance principle) at a rate of 0.1% of the value of equities and bonds. This study estimates the expected impact of the FTT on household savings arising through its effect on the value of equity and debt holdings. In particular, the effect considered is the instantaneous price adjustment resulting from the introduction of the tax: If the FTT is introduced, its expected costs would be capitalised into the price of assets subject to the tax and the price adjustment would take place practically instantaneously, thereby affecting the value of household equity and debt holdings and in turn household savings. There is a significant body of empirical evidence supporting the existence of instantaneous price adjustments Jackson, P.D. and O Donnell, A.T. (1985). The effects of stamp duty on equity transactions and prices in the UK stock exchange, Bank of England Discussion Paper, No Umlauf, S. (1993). Transaction taxes and the behaviour of the Swedish stock market, Journal of Financial Economics, 33, pp Saporta, V. and Kan, K. (1997). The effects of stamp duty on the level of volatility of UK equity prices, Bank of England Working Paper No

14 So far, most studies examining the impact of the FTT have focused on market impacts (liquidity, trading volumes, etc.), the impact on the functioning of some markets such as the repo market, the future returns to investors and the effect on the cost of funding for firms. However, as far as we are aware, no study has examined the impact of a FTT on the value of the securities portfolio (equity and debt) held by households. Yet, economic literature shows very clearly that the introduction of a tax on the trading of a particular asset has an almost instantaneous impact on the price of that asset. For example Oxera (2007) concluded that scrapping UK Stamp Duty would increase the price of shares by around 7.2%. Obviously, the decrease in the asset price caused by the introduction of a transaction tax reduces the value of the portfolio including such assets. Such a negative effect on the value of savings is a key channel 22 through which the FTT may impact negatively on the economy. A drop in the value of household savings typically leads to a decrease in consumption in the longer run. For example, studies from the ECB and the IMF suggest that a 10% decrease in the value of household savings reduces consumption (in real terms) by about 1% in the long run. 23 As household consumption accounts for between 56% and 62% of GDP (at constant prices) in the countries of interest (except Luxembourg), a substantial drop in the value of savings will have a significant negative impact on the long-run level of GDP. A special feature of the proposed FTT is that not only all trades in securities issued in an EU Member State participating in the FTT would be subject to the FTT (the issuance principle) but trades in securities issued in countries not participating in the FTT would also be subject to the FTT if one counterparty is from a country participating in the FTT (the residence principle). This report first considers the effects of the FTT on the value of savings through the issuance principle, and then the additional effects on the value of savings through the residence principle. At the time of publication, intermediaries in the trading chain between two endusers (i.e. investors) seem to be subject to the tax as well. This is a very important issue as the taxation of intermediaries in a trading chain results in a cascade effect and increases significantly the effective tax rate of each trade between end-users. To illustrate the impact of the FTT on the value of savings, the present study focuses on the effect of the FTT on household equity and debt holdings of six EU Member States, namely four countries participating in the FTT (Germany, Italy, Spain and Slovakia) and two EU Member States which do not participate in the FTT (United Kingdom and Luxembourg). The selection of countries aimed to achieve a good mix geographically and by country-size while also including a number of countries with deep capital markets. 20 Oxera (2007) Stamp duty: its impact and the benefits of its abolition, Report prepared for the ABI, City of London Corporation, IMA and London Stock Exchange, May. 21 Best, M.C. and Kleven, H.J. (2013) Housing market responses to transaction taxes: evidence from notches and stimulus in the UK. Mimeo. 22 Another channel is the impact of the FTT on the cost of capital. For a discussion of the impact of FTT on the debt component of the cost of capital, see London Economics (2013), The Impact of a Financial Transaction Tax on Corporate and Sovereign Debt, Report prepared for the International Regulatory Strategy Group (IRSG), TheCityUK and City of London, April. 23 Ricardo, S. (2009). Wealth Effects on Consumption, Evidence from the Euro Area. ECB Working Paper No. 1050/ May 2009 and Ludwig, A. and Sløk, T, (2002), Impact of Stock Prices and House Prices on Consumption in OECD Countries IMF Working Paper 02/01. 9

15 It is important to note that the t value of savings of households in the countries not participating in the FTT will also be affected by the introduction of the FTT if their equity and debt securities portfolio comprises equities andd debt securities issued in countries participating in the FTT. For the non-participatingg Member States, the United Kingdom was selected as the largest Member State to opt-out of the FTT, whilst Luxembourg providess an interesting case study duee to its largee holdings of financial assets relative to its size, a large proportion of which are external assets. A final point to note is that the availability of data varies considerabc bly across the three asset classes (equity, short-term debt securities and long-term debt securities) with much less information available in the case of debt securities. However, as equities are by far the asset which is traded most frequently, and trading frequency (together with the effectivee tax rate) is the most important driver of the impact of the FTT on the price of a security, the more limited availability of data does not a have a material impact on the conclusions of the study. 1.1 Household savings in equity and debt Household savings in equity and debtt were grouped into portfolios by: Country of issuer home andd abroad (by countries intending to participate and not participate in the FTT) ); and Asset class equity and debt. Portfolios were grouped in this t way too capture differences s in taxes one would expect the portfolios to attract. Firstly, assets issued in different countries change hands at different rates so households holding assets issued in countries wheree assets are tradedd more frequently are likely to see their assets taxed more. Andd secondly, with the exception of government debt, equities tend to be traded moree frequently than debt meaning that households that hold relatively more equity e thann debt are likely to see their assetss taxed more also. Data from two information sources were used to construct the financial portfolios: Data on the household financial portfolios of domestically and foreign issued equity and debt holdings, available from Eurostat; ; 24 Data on the distribution of household and country-wide financial portfolios in equity and debt across many y issuing countries, available from the IMF Coordinated Portfolio Investment Survey (CPIS). 25 The latter information was used to split the foreign component of thee Eurostat equity and debt portfolio into a portfolio of holdings from FTT-participating countries (other than the home country if the latter is a participating country) and FTT non- participating countries. 24 See Eurostat, European sector accounts, 25 The IMF data is available at 10

16 1.2 Geographic breakdown The level of household savings through equity and debt inn the six countries selected varies considerably, as shown in Figure 6. Figure 6: Household savingss in equity and debt, by country of issuer,, end 2011 Foreignn shares Other EU non- Non-EU non-- Value, Home participating participating participating bn share countries countries countries Participating countries Germany Italy Spain Slovakiaa Non-participating countries United Kingdom Luxembourg 1,066 1, % 72% 71% 76% 53% 12% 4% 5% 5% 4% 3% 13% 32% 19% 20% 16% 8% 8 22% 6% 4% 4% 4% 36% 53% Notes Securities subject to FTTT on basis of issuance principle Securities may m be subjectt to FTT when traded on basis b of residence principle 1 Excluding home country, if home country participating applicable Source: London Economics analysis of Eurostat sector accounts and IMF Coordinated Portfolio Investment Survey In the four participating Member States, Germany, Italy and Spain ss households hold substantially more assets than Slovakia s: In Germany, the total assets held by households is over EUR 1 trillion, which is equal to 41% of GDP; Italy has by far the highest level of household savings at EUR 1.67 trillion, which equates to over 100% of GDP. Italy s level of household savings is 57% greater than that off Germany, an economy nearlyy double the size of Italy. Although the value of household savings in Spain in i absolutee terms is much lower at EUR 500 billion, it equates to 48% of GDP. Slovakia, in contrast, has only EUR 3.6 billion of household savings or 5.3% of GDP. The investment patterns of all four countries shows a homee bias, i.e.,, that between 58% and 76% is invested in assets thatt are issued in their home market and only 4-6% is invested in assets from outside Europe. The picture in Luxembourg and the UK is quite different. Although the value off household savings in both countries iss equal to around 40% % of GDP, unlike the four participating Member States, the household savings of thee UK and Luxembourg are more likely to be invested in non-eu assets (between 36% and 53%). 11

17 1.3 Asset classs breakdown As will be noted in the next section, the value of assets which are frequently traded is much more sensitive to a transactionss tax than the value of assets which are infrequently traded and the trading frequency of equities is a multiple of the trading frequency of debts. Therefore, countries with a high sharee of equities subject to t the FTT in the overall portfolio will be moree affected by the FTT. In light of this, this section breaks down household savings in equity and debt by asset class. Equity, or shares, makes up the largest component of household financial portfolios in all six countries. In fact, in four of the countries examined (Germany, Spain, Slovakia and the UK), it exceeds 70% of the total portfolio. Figure 7: Household savingss in equity and debt, by asset class, c end 2011 Germany Italy Spain Slovakia United Kingdom Equities Short-term debt Long-term debt Luxembourg 0% 20% 40% 60% 80% 100% Source: London Economics analysis of Eurostat sector accounts and IMF Coordinated Portfolio Investment Survey 1.4 Cascade and the effective tax rate At the present time, the EC proposal does not exempt intermediaries in equity and debt transactions from the tax, as is the case for other taxes, such as the UK stamp duty and the French financial transactions tax among others. As such, the tax would be charged at multiple stages of the chain of settlement as well as for other associated transactions (namely, for hedging purposes), creating a "cascade effect" ". Information provided by industry specialists 26,27 suggests that a number of intermediaries may be involved in end-to-end transaction (as shown in Figure 8). 26 For debt see also London Economics (2013), The Impact of a Financial Transaction Tax on Corporate and Sovereign Debt, Report prepared for the International Regulatory Strategy Group (IRSG), TheCityUK and City of London, April. 27 For equities see Clifford Chance (2013), Financial Transactions Tax: Update, available at: /publicationviews/publications/2011/10/financial_transactiontaxupdat e.html 12

18 Figure 8: Exemplified FTT "cascade effect" for equity transaction (top) and debt transaction (bottom) Vendor Broker Clearing member CCP Clearing member Broker Pension fund 0.1% (if FI) 0.1% 0.1% 0.1% 0.1% (exempt) 0.1% 0.1% 0.1% 0.1% 0.1% Source: Clifford Chance (exemplified equity transaction) and London Economics (exemplifiedd debt transaction) Based on this information, itt is assumed in the subsequent analysis that, because of the cascade effect, the effective taxx rate would be in thee order of 1% (or 100bps) for securities issued in FTT countries. Transaction chains can be shorter than those shown in thee figure above. For instance, rather than a bond being transferred between end-investoe ors, which involve a 100bps tax incidence, an inter-dealer transaction may take t placee involving a smaller tax incidence. This means thee average tax per transaction chain will be less than 100bps. However, as the t impactt on the price of securities, andd value of securities holdings in turn, is determined by the marginal transaction, the 100bps cascade effect is the relevant effect and is used for the analysis. a For transactions qualifying through t thee residence principle, the effective tax rate is assumed to be 0.2% (or 20bps) as transactions in the chain of settlement between financial intermediaries in non-ftt countries would likely not incur thee FTT. However, in the case of equities, the implications of an alternative scenario under which all intermediaries are exempt from the tax, and only the ultimate buyer and seller have to pay the FFT are also reviewed. In such a case, the effective tax rate is 20 basis points. 13

19 1.5 Structure of the report The remainder of the report is structured as follows: Chapter 2 considers the expected FTT impacts due to the issuance principle impacts on: o equity holdings in section 2.1; o short-term debt holdings in section 0; and o long-term debt holdingss in section 0. Chapter 3 sets out the expected FTT impacts duee to the residence principle on: o after first detailing key assumptions in sectionn 3.1; o equity holdings in section 0; o short-term debt holdings in section 3.3; and o long-term debt holdingss in section 3.4. N.B. Each section first provides an overview of households affected holdings, then the methodology and finally key results. Chapter 4 provides a summary of resultss and conclusions 14

20 2 Expected FTT impacts the issuance principle Equity holdings Overview of households holdings The present section estimates the impact on the value of householdd savings arising from application of the FTT on equity trading. The analysis considers only the application of the FTT on an issuance basis as the issue of the application on a residence basis is discussedd later in the report. As explained, the proportion of the portfolio invested in the home market (for participating countries) and other participating countries will increase the impact of the FTT on the portfolio as a whole. Ass Figure 9 shows, the percentage of the financial portfolios invested in assets liable to the FTT is high in all four participating Member States, ranging from 89% in Slovakia to 65% in Germany. In the UK and Luxembourg on the other hand, the percentage of equityy holdings that is liable to the FTT is 3% and 13% respectively. Figure 9: Household savingss in equity,, end 2011 Participating countries Germany Italy Spain Slovakiaa Non-participating countries United Kingdom Luxembourg Value, bn Home share 63% 68% 70% 87% 53% 17% Other participating countries 1 2% 5% 5% 2% 3% 13% Foreignn shares EU non- countries participating Notes Securities subject to FTTT on basis of issuance principle Securities may m be subjectt to FTT when traded on basis b of residence principle 1 Excluding home country, if home country participating applicable Source: London Economics analysis based on Eurostat sector accounts and the IMFF Coordinatedd Portfolio Investment Survey. 30% 25% 22% 10% 8% 8 17% Non-EU non-- participating countries 5% 2% 3% 1% 36% 53% 15

21 2.1.2 Methodology The change in value of an asset with an infinite life when an ad-valorem transactions tax is introduced can be approximated by the following equation (see Matheson, 2011): (1) Percentage change in value = 1 [(1-e-RN)/(1-(1-T)e-RN)] where R is the discount rate (net of dividend growth if relevant), T is the ad valorem tax rate and N is the holding period of the security. In other words, the reduction in the value of an asset resulting from the imposition of a transactions tax on the trading of that security is a function of: The tax rate; The holding period; and, The discount rate. The value of the loss of the asset increases with the tax rate and decreases with the length of the holding period and the discount rate. For example, if a tax of 100 basis points were applied to an asset with an average holding period of one year, the decrease in value would be 24.7% but if the average holding period were 10 years, the decrease in value would be only 2.8%. Of particular importance for the present study is the result that, for given tax and discount rates, the loss in value increases rapidly with the trading frequency of the security. For example, when the holding period of a security drops from five years to one year, the loss in the value of savings resulting from a transactions tax of 25 basis points increases from 1.5% to 7.6%. 16

22 The estimation for the present study of the reduction in the value of the equity portfolio uses equation one above. The key inputs into the equation are the tax rates, the discount rate and the length of the holding period (or the inverse of the number of times a security trades over its life). The following values were used for these three parameters: Tax rate: The baseline scenario assumes that the effective tax rate is 100 basis points (bps). 28 The results of an alternative scenario with an effective tax rate of only 20 basis points are presented as well in summary form. The latter scenario assumes that financial intermediaries are exempt from the tax. Discount rate: A net discount rate (i.e. discount rate net of dividend growth rate) of 3% is used. For a given tax cost, the discount rate accounts for said cost being lower if faced tomorrow rather than today. Such a rate was also used in the IMF/Matheson study. Holding period: The actual 2011 turnover rate (i.e. annual turnover/average market capitalisation during the year) 29 was used. 30 The computed average holding period for home country equities and equities from other FTT countries is shown in Figure With the exception of Slovakia, the equity portfolios turn over quite quickly, with the average holding period ranging from 0.8 year to 1.4 year (see Figure 10). Figure 10: Average equity holding periods, years Participating countries Germany Italy Spain Slovakia Non-participating countries United Kingdom Luxembourg Domestic issuers Foreign issuers Note: 1 FTT participating countries only Source: London Economics analysis of turnover and market capitalisation data from FESE and European stock exchanges. 28 See Section1.4 for details 29 The information was sourced either from the annual statistics published by FESE or from the statistics produced by the various stock exchanges. 30 It is important to note that the impact of a transaction tax depends on the overall trading frequency of a security and not on the trading frequency of the security held in a particular portfolio. 31 Of note is the fact that average holding period for each country s portfolio consisting of non-home equities is derived from the weighted average of the turnover rates on the stock exchanges of the various FTT countries. The weights are in cases equal to the share of the various FTT countries equities in the total portfolio of FTT equities of the particular country. Thus, for each of the six countries, a countryspecific holding period of equities subject to the FTT other than from the home country was derived and used in the analysis. 17

23 2.1.3 Results The results of the simulations reported in Figure 11 show very clearly the large potential impact of the FTT as currently proposed. Figure 11: Expected impact of proposed FTT issuance principle on equity holdings under two different effective tax rates 0.0% 5.0% DE IT ES SK UK LU 0.6% 0.2% 0.9% 1.1% 3.1% 4.7% 5.3% 4.7% 4.3% 10.0% 15.0% 20.0% 18.4% 20.5% 19.0% 25.0% 100 basis point effective tax rate 20 basis point effective tax rate Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio Investment Survey The value of the overall equity portfolio of Germany, Italy and Spain drops by 18% to 20%. However, the value of the Slovak equity portfolio drops relatively little due to the fact that the domestic equity portfolio is characterised by a very long holding period (10 years). In the case of the United Kingdom and Luxembourg, the value of the total equity portfolio would drop by 1% and 4% respectively. The much smaller impact of the FTT on the equity portfolios of these two countries relative to the impact shown for Germany, Italy and Spain reflects the much smaller share of equity holdings subject to the FTT in their overall equity portfolios. If intermediaries in the trading chain were to be exempt from the FTT and the effective tax was only 20 bps instead of 100 basis points, the effects on the value of savings would be much smaller. For example, in the case of Germany, Italy and Spain, the loss in value would only be in the range of 5% as compared to between 18% and 20%. 18

24 2.2 Short-term debt holdings Overview of households holdings Following the estimation of the impact of the FTT on the value of thee equity portfolio, the present section provides estimates of the impact of the FTT on the short-term debt securities portfolio of the t countries of interest. As already noted the countries portfolios in short-term debt holdings are very small in comparison to the size off the equityy and long-term debt holdings. In particular, according to the Eurostat sector accounts, at the end of 2011 Slovakian households held no short-term debt securities. Moreover, with the notable exceptionn of Luxembourg, thee majority of short-term debt holdings is domestic. Figure 12: Household short-term debt holding, end 2011 Foreignn shares Other EU non- Value, Home participating participating bn share countries countries Participating countries Germany Italy Spain Slovakia Non-participating countries United Kingdom Luxembourg % 95% 95% -- 56% 2% 19% 1.5% 2.2% -- 5% 25% 28% 3..1% 0..5% -- 7% 7 26% Non-EU non-- participating countries Notes Securities subject to FTTT on basis of issuance principle Securities may m be subjectt to FTT when traded on basis b of residence principle 1 Excluding home country, if home country participating applicable Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio 4% 0.4% 2.3% -- 31% 47% Methodology Short-term debt holdings comprise debt securities originally issued with a maturity of less than one year. One complication in estimating the effect of a FTT on the value of short-term debt is that, at any point of time, such a portfolio will include debt securities which may mature shortly. Moreover, the total volume of tradingg of short-term assets during a given yearr does not provide a good indication of the size of the portfolio which w will be impacted by a FTT as such trading may include securities with a short maturity issued and redeemed in between the annual dates at which the portfolio is valued. For example, a three-month security mayy be issued in February and traded once or several times during its life and yet it will not be included inn portfolioss valued on the 31 st of December of each year. 19

25 Therefore in order to derive an estimate of the impact of the FTT on the value of short-term securities portfolio, a number of assumptions had to be made regarding: The effective tax rate: this rate is assumed to be 100 bps as in the case of equities. The share of the portfolio which can be traded during the year: it is assumed to be one half or 50%. The frequency of trading of the portfolio that can be traded. Based on trading data provided by Tradeweb and then portfolio data from Eurostat, we assume that in countries with deep capital markets (that is, with many buyers and sellers actively trading), half of the portfolio that can be traded is actually traded and in markets with thinner capital markets (that is, with few buyers and sellers actively trading), only one tenth of the portfolio that can be traded is actually traded. As the portfolio of short-term debt securities is relatively small, changes to the assumptions above will not have a major effect on the overall estimate of the impact of the FTT on the value of savings Results The results in Figure 13 show that the estimated impact of the FTT on short-term securities is small (between 0 and 0.2%), reflecting the assumed low trading frequency. A higher trading frequency will increase the estimated impact. But, in absolute terms, the effect will still be small compared to the impact on the equity portfolio due to the small size of the short-term securities portfolio itself. Figure 13: Expected impact of proposed FTT issuance principle on short-term holdings Impact of FTT on total value of short-term debt holdings Participating countries Germany -0.2% Italy -0.2% Spain -0.1% Slovakia -- Non-participating countries United Kingdom -0.0% * Luxembourg -0.1% Note: * = smaller than -0.05% Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio 20

26 2.3 Long-term debt holdings Overview of households long-term debt holdings The geographical pattern of the holdings of long-term debt securities varies much more across the countries of interest than in the case of equity holdings and short- term debt holdings. For example, the home bias is much stronger s in Italy and Spain than the other four Member States. This means that the share of the portfolio subject s to the FTT due to the issuance principle in these two countries is overr 80% as opposed to 50% in Germany and 4% in the UK. Figure 14: Household long-term debt holding, end 2011 Participating countries Germany Italy Spain Slovakia Non-participating countries United Kingdom Luxembourg Value, bn Home share 42% 78% 79% 47% 39% 3% Other participating countries 1 Notes Securities subject to FTTT on basis of issuance principle Securities may m be subjectt to FTT when traded on basis b of residence principle 1 Excluding home country, if home country participating applicable Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio 10% 5% 1% 10% 4% 13% Foreignn shares EU non- countries participating 38% 11% 8% 8 31% 14% 32% Non-EU non-- participating countries 10% 6% 12% 13% 43% 52% Methodology Everything else being equal, the impact of a transaction tax t on a fixed rate security can be derived by using equation 1).. The equation states that the percentagee reduction in the value of a security is equal to the sum of the tax rates applied to the security over its life time (accounting for the discount ratee that is, for the factt that tax costs faced in the future are lower in present value terms). The sum depends on the number of times the security is traded before it is redeemed. (1) Percentage change in value = T/1 D k where T is the ad valorem tax rate, D is the discount rate and a the variable k reflects the years during which the securities is traded. For example k=1 andd 5 would indicate that the security was traded in years 1 and 5 of the time horizon overr which the analysis in undertaken. 21

27 The assumptions used in the estimation of the impact of the FTT on the value of the long-term debt securities portfolios of the countries of interest are the following: The discount rate is 5% 32 ; The tax rate is 100 bps; The time horizon is ten years, as it is assumed long-term debt matures after this time; In deep financial markets, in which buyers and sellers trade actively, the security is assumed to trade twice over its life (in years three and six) and once in thinner markets (in year five). These assumptions are based on an analysis of some aggregate trading data from Tradeweb and Eurostat sectoral accounts Results Overall, the impact of the FTT on the value of portfolios of long-term debt holdings is small, reflecting the fact that such assets are infrequently traded. For the FTT countries, the estimated impact ranges from a loss in value of 0.5% to 1.3% of the initial portfolio value and for the United Kingdom and Luxembourg, the reduction in the overall value ranges from 0.1% to 0.2%. Figure 15: Expected impact of proposed FTT issuance principle on long-term holdings Impact of FTT on total value of long-term debt holdings Participating countries Germany -0.8% Italy -1.3% Spain -0.6% Slovakia -0.5% Non-participating countries United Kingdom -0.1% Luxembourg -0.2% Source: London Economics analysis based on Eurostat sector accounts and the IMF Coordinated Portfolio 32 This is consistent with that applied above for equities. In the case of equities, a net discount rate of 3% per annum was used, which was comprised of a discount rate of 5% subtract dividend growth of 2%. For short- and long-term debt, since there is no dividend growth, a discount rate of 5% per annum is used. 33 These assumptions may be conservative as, for instance, government bonds are traded more frequently. However, as long as the trading frequency remains low, small changes in the assumption about the number of times the security trades does not have a major impact on the estimate of the impact of the FTT on the value. 22