Finding a Solution to The Taxation of Securities Transfers: Taxable Capital Asset vs Non-Taxable Ordinary Income Transactions

[Original Title: An Analysis of Securities Transaction Tax Proposals Submitted in Congress Since the Financial Crisis of 2007-2009. Written for Professor Norman Richter's Tax Policy Class at Boston University, Fall 2017.]

1.   Introduction and Overview

The Financial Crisis of 2007-2009 that peaked with the collapse of Lehman Brothers in September 2008 resulted in a populist wave that, in part, brought the Democrats and Barack Obama to power. In 2009 and 2010, Congress in rapid succession passed and implemented various measures in response to the financial crisis – including the Dodd Frank Act – that imposed greater disclosure, better governance, and higher transparency requirements on the securities industry.[1] While a Securities Transfer Tax (also referred to as a “Financial Transfer Tax” hereinafter either “STT” or “FTT”) was also proposed and introduced to Congress during this time period, it never reached debate. Bills introduced since then suffered the same fate.

This paper will review the legislative attempts to impose an STT, analyze the texts of the proposals, and then analyze the policy goals of adopting an STT. The paper concludes that the STT as proposed so far would not only be economically inefficient but would also present problems of fairness, simplicity, administrability, and certainty. This paper therefore suggests an alternative approach to implementing an STT.

2.    Legislative Attempts to Impose an STT in the United States

The idea of a tax on securities transactions goes back as far as the British Stamp Tax of 1694[2] and has been applied at various stages in American history. On the federal level, most recently, an STT was in place between 1914 and 1966. And on the state level, some states (most notably New York) continue to have an STT in place.[3] In addition, Section 31 of the Exchange Act imposes a fee upon exchanges and self-regulatory organizations that are passed on to broker-dealers and paid based upon the volume or size of transactions.[4] The fee is levied on futures transactions, but not on debt instruments.[5] While the STT was proposed at various times after its repeal in 1966,[6] it was in the context of the financial crisis of 2007 – 2009 that a drive to reinstitute an STT began in Congress.

In 2008, Representative DeFazio proposed an STT.[7] Relying on its success in raising revenue during the Great Depression, the proposed tax was aimed at offsetting the $700 billion in bailout money issued by the government to prevent a market meltdown.[8] The proposed tax mirrored SEC Section 31 by taxing trading facilities 0.25 percent of any securities transaction falling within sections (b), (c), or (d) of that section.[9] In addition, the tax would also have applied to any transaction under the jurisdiction of the Commodity Futures Trading Commission.[10] According to Congress.Gov, the Bill was referred to the House Ways and Means Committee on September 26, 2008 but apparently was not marked up nor submitted to the House for voting.[11]

In 2012 and 2013, Representative Keith Ellison introduced a bill to “impose a tax on certain trading transactions to strengthen our financial security, expand opportunity, and stop shrinking the middle class.”[12] In contrast to Representative DeFazio’s bill, Representative Ellison’s proposed Inclusive Prosperity Act did not rely on SEC Section 31 to classify taxed securities but defined the categories within the proposed legislation. However, the legislation also proposed taxing “any partnership or beneficial ownership interest in a partnership or trust”, apparently to fully capture hedge transactions.[13] At the same time, securities transactions exempted under Section 1058 of the Internal Revenue Code were also exempted under the proposed legislation, as were initial issues, and notes and debentures with a term of less than 60 days.[14] Furthermore, taxes were imposed based on the securities value on the day of the trade (marked-to-market)[15] and individuals with an annual income of less than $50,000 could claim a credit for any tax incurred.[16] Finally, failure to report the tax would have been subject to a penalty.[17]

Although there is no indication that either of Representative Ellison’s bills were submitted by the House Ways and Means Committee to the House Floor for a vote, Senator Bernard Sanders submitted the same text to the Senate Committee on Finance in 2015 and 2017.[18] In addition, Representative Ellison referred the bill to the House Ways and Means Committee again on March 15, 2015[19] and introduced it to the House on February 16, 2017.[20] Neither of the bills have moved forward (possibly because of the Process through which bills are marked up and reported to Congress), but it is clear from this review that the Personalities of Ellison and Sanders have as much to do with the tax still being in Congress’s radar as do Policy, and Politics.

3.   Evaluation of STT Proposals

The STT is in effect a transfer payment that aims to fund government works projects while alleviating the revenue constraints imposed by tax cuts and rebates.[21] The tax is “imposed on a financial transaction, … may be assessed on the buyer, the seller, or both, and is typically an ad valorem tax, that is, [the STT taxes] a percentage of the market value of the security that is traded.”[22] Also called the “Robin Hood Tax”, proponents argue for the tax because the tax base (the sheer number, volume, and value of financial transactions) is enormous and the tax potentially curbs short-term speculation, reduces asset price volatility and related bubbles, encourages longer-term investment, and primarily falls on the rich.[23] Opponents of the tax argue that the tax is generally inefficient, falls on intermediate inputs in the production process, is likely to cascade and distort economic activity, would reduce market liquidity by raising the cost of capital, increase asset price volatility, does not address the factors that actually lead to that excess leverage which leads to systemic risk, and ends up burdening the middle class due to expected cost shifts that would, inter alia, fall on retirement savings.[24]

a.   Interference with Economic Efficiency

The strongest argument against implementation of an STT is that it interferes with economic efficiency. It does so by distorting economic activity in transaction areas that do not reduce systemic risk nor curb short-term speculation.[25] As pointed out in class lectures, this line of reasoning does assume that taxpayer (and in this case discussion, traders and investment bankers) are rational actors that take tax effects into consideration. While in the class example, it was pointed out that most companies respond to changes in earnings before income tax (EBIT), it is conceivable that a tax on each securities trade or transaction would have a direct effect on earnings, since such a tax would presumably reduce outright the main point of earnings for the industry (fees generated on transactions).

To understand why this is the case, it helps to look at the tax shift that can tax place when one country imposes one tax on a financial transaction while a similarly situated country does not. In that case, the real interest parity between the two countries is assumed to “hold as long as financial markets are free of any controls or distortions.”[26] However, when borrowing and interest costs differ in different currencies and real costs are affected by different inflation rates,[27] distortions occur which in general are caused by national and international capital and capital flow controls, the expected nominal costs of financing, and the expected deviation of inflation rate from purchasing power parity.[28]

Thus a tax that is imposed on a capital flow in one country but not in another will theoretically cause an economic shift away from the tax-imposing country provided real interest parity exists between the two (that is, where the real borrowing costs (loan rate and expected inflation rate) are otherwise the same or equivalent).[29] This would explain why a proposed EU-wide financial transfer tax that was supposed to be implemented in January 2017[30] has not been implemented.[31] Indeed, a view from economic efficiency reaffirms the idea that Politics play as much of a role in tax formation as Policy, Process, or Personalities. Accordingly, adoption of an STT would likely cause traders to look for investment opportunities that would help the bottom line by not being taxed.

b.   Fairness

The strongest argument for an STT is that of fairness. Representative DeFazio, in submitting his Putting Main Street First Act in 2016, made the argument for an STT by pointing to “the reckless greed of Wall Street” that has caused “the American economy [to become] a grossly unbalanced playing field” requiring “Wall Street to pay its fair share in taxes.”[32] Senator Sanders also supported the tax because he believed that Wall Street should “return the favor” for getting “a big boost when U.S. taxpayers bailed out some of the largest financial institutions in 2008.”[33] Indeed, the structure of the Sanders-Ellison bill emphasizes vertical equity in that it is progressive and provides a credit for low-income earners who trade in stock. The credit too appears aimed at countering the argument that the end consumer would ultimately bear the burdens of the transaction tax.

Fairness arguments in the context of Wall Street have great appeal to the common man. There is no doubt that our infrastructure suffers from a lack of investment and that the education system is highly disparate and expensive.[34] Ostensibly, a tax on Wall Street would work against income inequality and level the income playing field. However, from my own experience trying to establish a meaningful loan portfolio, it appears to me that the fairness argument is one that does not take the realties of securities trading into consideration. Given transaction costs and fees, to actually make a meaningful return from securities arbitrage, short- or long-selling, or hedge transactions, an individual would have to invest $100K or more in any given stock and multiply that across industries in order to develop a sufficient cushion against volatility.[35] An increase in transaction fees through an STT would raise that threshold; that is, it would make it even more difficult for an individual to create a securities portfolio that would be secure against market volatilities and provide a meaningful return. Extrapolated to money market funds and similar pooling vehicles that seek to maximize returns while ensuring security for interest holders, it would appear that in final analysis the end consumer would, indeed, by the one bearing the brunt of the burden.

c.    Simplicity and Compliance

There are two streams in the proposed STT response. The one stream is represented by Representative DeFazio’s bills. That stream is simple and bounces off a fee system already in place that is administered by SROs. The other stream is reflected in the bills submitted by Representative Ellison. That stream is more complex, seeks to emphasize fairness over simplicity, and as a result makes planning certainty more difficult.

In analyzing both streams, it is clear that the drafters focused more on the type of the transaction than on the type of asset / security being taxed. American tax law, as interpreted by the Supreme Court, classifies securities transactions into those generating income (and thus subject to income taxation) and those that are investments (and thus taxed as capital assets). In Corn Products Refining Co. v. Comm’r, 350 U.S. 46 (1956), the Supreme Court held that where a securities transaction acts as insurance that protects inventory or other assets, it should be taxed as ordinary income. Id. at 52-54. By contrast, in Arkansas Best Corp. v. Comm’r, 485 U.S. 212 (1988) the Court narrowed Corn Products and held that stock transactions which are not otherwise excluded from Section 1221 (defining capital assets) should be taxed as capital assets. Arkansas Best at 220-23. Hedging transactions that are an integral part of a business’s inventory purchase system, fall within the inventory exclusion of 1221 and are thus subject to ordinary income. Id. at 221-22. Following this line of reasoning, transactions that help businesses operate and protect them from the volatilities of the commodities markets (or markets in general) should not be subject to an STT. While transactions that are entered into for investment reasons and are taxed ordinarily as capital assets should be subject to an STT. This classification into taxable capital asset transactions and non-taxable ordinary income transactions would build on tax regulations and jurisprudence while at the same time also further the notions of fairness raised by Representatives DeFazio and Ellison and Senator Sanders.

d.   Administrability and Enforceability

As pointed out in our class, complexity increases costs of compliance. While apparently simple on their face, both the DeFazio and Ellison streams of taxing STT would require complex regulations that would necessarily have to focus on developing regulations to define transactions subject to the STT. Of course, the DeFazio bill that parrots SEC Section 31 makes administrability easier because the IRS ostensibly already has experience in collecting taxes through SROs. Still, even former Treasury Secretary Geithner believed that “firms are ‘going to move in a heartbeat to get around any tax like that.’”[36]

Indeed, behavioral effects could complicate enforceability[37] and result in a potentially significant reduction in revenue yield.[38] Thus, the alternative of drafting legislation that follows current securities classification by dividing transactions into those that trigger ordinary income and those that are taxed as capital assets may make enforceability easier – if only for the reason that the Internal Revenue Service already has significant experience with classifying securities as ordinary income versus capital assets.

To ensure administrability under either of the streams or the proposed alternative, however, it would appear prudent for the Internal Revenue Service to require access to the traders’ electronic data to verify transactions. Setting aside privacy concerns, were the Service able to obtain and track each electronic transaction falling within the scope of STT legislation, it could also verify that the appropriate tax was collected for each transaction.[39]

e.   Planning Certainty[40]

Both the DeFazio stream and the Ellison-Sanders stream of proposed STT would likely create unnecessary compliance costs and possibly significant confusion as to what type of a transaction falls within the scope of the legislative language. To avoid the uncertainties created especially as markets evolve and new financial instruments are created to meet evolving financing needs, developing an STT built on the income / capital asset distinction makes more sense. Under such a taxing scheme, both traders and the Internal Revenue Service could utilize a long history of 1221 interpretation and jurisprudence to clearly demarcate transactions that are subject to taxation and those that are not.[41]

4.   Conclusion

Since in most economies (including the United States) loan transactions are more important than direct financing in the securities markets, blanket STTs that apply to all transactions would stifle hedging transactions that act as insurance (subject to ordinary income tax) and simultaneously fail to fully target speculative hedging transactions derived from loan transactions (subject to capital gains tax).[42] The analysis of STTs introduced in Congress since the financial crisis, suggests that the adoption of an STT system based on Section 1221 classification of securities transactions as insurance versus investments would better serve the purpose of raising revenue, ensuring fairness, and allowing investors some level of planning certainty at the same time as the Internal Revenue Service could secure compliance through administrability. Under such an approach, transactions that help businesses operate and protect them from the volatilities of the commodities markets (or markets in general) would not be subject to an STT; while transactions that are entered into for investment reasons and are taxed ordinarily as capital assets would be. Nevertheless, it appears (at least from review of current legislative responses in Europe) that an STT would not be economically efficient regardless of the approach taken.

Bibliography

Alexander, Carol and Elizabeth Sheedy, The Professional Risk Manager’s Guide to Financial Markets, McGraw-Hill Finance & Investing (2008).

Bird, Richard M., Global Taxes and International Taxation: Mirage and Reality (Part 1), 27 J. Int’l Tax’n 50 (2016).

Burman, Leonard E., William G. Gale, Sarah Gault, Bryan Kim, Jim Nunns, and Steve Rosenthal, Financial Transaction Taxes in Theory and Practice, 69 National Tax Journal 171-216 (2016).

DeFazio, Peter, Press Release (Rep. Peter DeFazio Introduces Legislation to Curb Speculative Wall Street Trading and Bolster Main Street), July 13 2016 (accessed November 5, 2017 at https://defazio.house.gov/media-center/press-releases/rep-peter-defazio-introduces-legislation-to-curb-speculative-wall-street).

H.R. 7125, Let Wall Street Pay for Wall Street’s Illiquid Assets Act of 2008, 110th Congress, 2nd Session (2008) (https://www.congress.gov/bill/110th-congress/house-bill/7125/text).

H.R. 6411, Inclusive Prosperity Act, 112th Congress, 2nd Session (2012) (https://www.congress.gov/bill/112th-congress/house-bill/6411/text).

H.R. 1579, Inclusive Prosperity Act, 113th Congress, 1st Session (2013) (https://www.congress.gov/bill/112th-congress/house-bill/6411/text).

H.R. 1464, Inclusive Prosperity Act, 114th Congress, 1st Session (2015) (https://www.congress.gov/bill/114th-congress/house-bill/1464).

H.R. 1144, Inclusive Prosperity Act, 115th Congress, 1st Session (2017) (https://www.congress.gov/bill/115th-congress/house-bill/1144/text).

Keightley, Mark P., A Securities Transaction Tax: Financial Markets and Revenue Effects, Congressional Research Service (April 19, 2010).

S. 1371, Inclusive Prosperity Act of 2015, 114th Congress, 1st Session (2015) (https://www.congress.gov/bill/114th-congress/senate-bill/1371/history).

S. 805, lusive Prosperity Act of 2017, 115th Congress, 1st Session (2017) (https://www.congress.gov/bill/115th-congress/senate-bill/805/text?q=%7B%22search%22%3A%5B%22s805%22%5D%7D&r=1). 

Marston, Richard C., International Financial Integration: A Study of Interest Differentials Between the Major Industrial Countries. Cambridge University Press (1995).

Marston, Richard C., Investing for a Lifetime: Managing Wealth for the ‘New Normal’, John Wiley & Sons, Inc. (2014).

Roubini, Nouriel and Stephen Mihm, Crisis Economics: A Crash Course in the Future of Finance, The Penguin Press (2010).

Tax on Transfers of Stock and Other Corporate Certificates, N.Y. Consol. Laws, Tax, Article 12.

U.S. Securities and Exchange Commission, Fast Answers, Section 31 Transaction Fees (accessed online November 5 2017 at https://www.sec.gov/fast-answers/answerssec31htm.html).

Weber, Alexander, Brexit Kicks EU Financial Transaction Tax Into the Long Grass, Bloomberg Markets, September 16, 2017 (accessed November 5, 2017 at https://www.bloomberg.com/news/articles/2017-09-16/brexit-kicks-eu-financial-transaction-tax-into-the-long-grass).

Zarroli, Jim, How Bernie Sanders’ Wall Street Tax Would Work, National Public Radio Morning Edition, February 12, 2016 (accessed November 6, 2017 at https://www.npr.org/2016/02/12/466465333/sanders-favors-a-speculation-tax-on-big-wall-street-firms-what-is-that).

[1] There are generally 3 accepted (Keynsian) responses to a financial crisis: Stimulate demand through government works projects, tax cuts and rebates, and transfer payments. Roubini at 161-63.

[2] Burman at 175.

[3] N.Y. Tax on Transfers, Article 12.

[4] 15 U.S.C. 78ee. See also, U.S. SEC, Fast Answers.

[5] Burman at 175.

[6] Keightly at 21.

[7] H.R. 7125.

[8] H.R. 7125, Sec. 1(b).

[9] H.R. 7125, Sec. 2, proposing Section 4475 to the Internal Revenue Code, titled “Tax on Securities Transactions.” Sub-sections (b), (c), and (d) of Section 31 (15 USC §78ee) respectively cover fees on exchange-traded securities, off-exchange trades or exchange registered and last-sale-reported securities, and security futures transactions.

[10] H.R. 7125, Sec 2.

[11] See https://www.congress.gov/bill/110th-congress/house-bill/7125/text (accessed November 5, 2017).

[12] H.R. 6411 was referred to the House Ways and Means Committee on September 14, 2015 (see https://www.congress.gov/bill/112th-congress/house-bill/6411/actions (access November 5, 2017)) and H.R. 1579 was referred to the Committee on April 16, 2013 (see https://www.congress.gov/bill/113th-congress/house-bill/1579/text)).

[13] H.R. 1579, Sec. 3(a)(e)(1)(B) and H.R. 6411, Sec. 3(a)(e)(1)(B).

[14] H.R. 1579 and H.R. 6411, Sec. 3(a)(f).

[15] H.R. 1579 and H.R. 6411, Sec. 3(a)(c).

[16] H.R. 1579 and H.R. 6411, Sec. 4(a).

[17] H.R. 1579 and H.R. 6411, Sec. 3(b).

[18] S. 1371 and S. 805.

[19] H.R. 1464 (2015) (see https://www.congress.gov/bill/114th-congress/house-bill/1464).

[20] H.R. 1144 (2017) (see https://www.congress.gov/bill/115th-congress/house-bill/1144).

[21] Burman at 172.

[22] Burman at 173-74.

[23] Burman at 172.

[24] Burman at 172.

[25] Burman at 177-78 (pointing out that the adoption of a financial transfer tax in Sweden and France did little to reduce systemic risk or curb speculation and rather resulted “in lasting harm to the Swedish stock market” and “reduced trading volume significantly” in France).

[26] Marston (1995) at 5.

[27] Marston (1995) at 5.

[28] Marston (1995) at 6-8.

[29] Marston (1995) at 3-5. See also Alexander at 25.

[30] Burman at 178. See also Bird at 55.

[31] Weber (pointing out that Brexit has created a fear that London-based banks would not move to Frankfurt after Brexit if the tax were implemented; or would move to Ireland or Luxembourg as those two nations would not implement a financial transactions tax).

[32] DeFazio.

[33] Zarroli.

[34] For example, in seeking to reframe my own aspirations, I have incurred more than $500,000 in student loans so far. And repayment could be a burden if I fail to monetize my education (raising the equity question which Sanders seems to target: Is education for knowledge or for finding a way to make money?).

[35] See generally Marston (2014)

[36] Keightley at 5.

[37] There is an odd belief that traders are really sophisticated and would easily find ways to circumvent any STT. See e.g. Zarolli (quoting John Cochrane, senior fellow at the Hoover Institution: “’The cleverness of our financial engineers shouldn’t be underestimated.’”).

[38] Keightley at 15.

[39] For example, the EU has implemented a VAT Information Exchange System to validate VAT identification numbers (https://ec.europa.eu/taxation_customs/vies/faq.html) and digital taxation is spreading across the world (https://quaderno.io/blog/digital-taxes-around-world-know-new-tax-rules/).

[40] I apologize that I haven’t been able yet to digest Module 6.

[41] I haven’t discussed the issue of taxing municipal and state bonds. Both the DeFazio and Ellison-Sanders streams exempt government bonds from taxation. To me, that undermines their argument that their version of the STT is aimed at combatting speculation; since speculation in municipal bonds was one of the principal triggers for the financial crisis. Focusing on taxable capital asset transactions and non-taxable ordinary income transactions instead would avoid the political question of whether a particular type of transaction should or should not be taxed because of the parties involved and would rather focus on the substance of the transaction as an investment versus insurance.

[42] See e.g. Marston (1995) at 9. 

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