Dr. William Barclay Chicago Political Economy Group Testimony to Illinois Legislative Pension Committee Hearing July 8, 2013

Reframing the Debate: A Revenue, Not a Spending, Problem

Dr. William BarclayChicago Political Economy Group

Testimony to Illinois Legislative Pension Committee HearingJuly 8, 2013

Dr. William Barclay, CPEG 2

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 - Background

7/8/2013

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.

A Revenue Source

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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

FTTs Around the World

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HR 1554 - An Illinois Financial Transaction Tax (FTT)

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.

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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

A Very Modest CPEG Proposal: An Illinois FTT of $1/Contract

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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.)

What Instruments Would Have an FTT?

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2008 2009 2010 2011 2012$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

Total Revenue

Total Revenue

US

$ B

illion

s $6.6 $6.1

How Much Revenue Could a $1/contract FFT Raise?

$6.1

$4.6$5.2

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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).

All Taxes Face Counter Arguments

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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.

The Economic Arithmetic of an FTT: Exchanges

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Consider 3 very active futures contracts: Corn:

◦ Each contract is for 5000 bushels◦ Smallest price change (minimum tick) is $0.0025 = $12.50

E-Mini S&P 500:◦ Each contract is $50 x the index (about $81,000 today)◦ Minimum tick (smallest price change) is .25 index points =

$12.50 10 Year T-Note:

◦ Each contract of for $100,000 face value◦ Minimum tick is 1/64 of a point = $15.625

A $1/contract FTT is less than the minimum tick.

The Economic Arithmetic of an FTT for Traders: I

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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.

The Economic Arithmetic of an FTT for Traders: II

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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.

The Economic Arithmetic of an FTT for Traders: III

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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.

Administering an FTT

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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, broker-

dealers◦ High-income individuals◦ Day traders

Who Would Pay the FTT?

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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.

FFT: A Tax for the People, Not on the People

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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.

An FTT is Good Tax Policy

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“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

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A Graduated Income Tax

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.

Taxes in Illinois

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A Graduated Individual Income Tax (GIT) for Illinois 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.

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Comparing Illinois to Other States 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.

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Raising Revenue by Closing Tax Loopholes

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

Six Large IL Tax Loopholes

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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

IL Tax Loopholes vs. Pension Funding Gap

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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.

A Summing Up

7/8/2013

Dr. William Barclay, CPEG 287/8/2013

Documents

Dr. William Barclay Chicago Political Economy Group Testimony to Illinois Legislative Pension Committee Hearing July 8, 2013