Viewpoints : Securities Taxes Might Shift Trades to Europe

Frantically searching for new revenue sources to avoid the Gramm-Rudman cuts on Oct. 1, Congress is now seriously considering two taxes on securities transactions. One is an excise tax equal to 0.5% of the value of every security purchased or sold in the United States. The other is a capital gains tax on any foreigner selling more than 10% of a U.S. company’s stock.

While these taxes may seem to offer the quick fix Congress is seeking, both would significantly reduce the volume and liquidity of U.S. capital markets.

Although both taxes are aimed at politically unpopular groups--wealthy traders and foreign investors--both taxes would in fact impose burdens on a broader array of voters. This is because both tax proposals fail to recognize that the securities markets are international and mobile. Raising taxes on securities transactions in the United States would push many investments and trades to other countries.

The excise tax on securities trades is designed primarily as a political response to the critics of President Bush’s proposal to cut capital gains tax rates. The critics argue that this cut would disproportionately benefit wealthy investors, so the rich should be hit with an offsetting tax burden. The excise tax is apparently viewed as a tax on the wealthy.

However, this tax would fall heavily on middle-income families who own securities through institutional investors--pension plans, mutual funds and insurance companies. Over half of the trading volume on the New York Stock Exchange is from institutional investors, which hold over $1.5 trillion in equities. The pension plans for California teachers and public employees, for example, would pay over $200 million per year on securities purchases alone under the proposed excise tax.

A secondary objective of this excise tax is to reduce volatile movements in stock prices. It is true that a 0.5% tax on every securities trade would significantly reduce the volume of securities trading because the tax is so large relative to normal transaction costs. In a normal trade of a $50 stock by an institutional investor, the brokerage commission would be 4 to 8 cents per share, while the excise tax would be 25 cents per share.

But lower trading volume does not necessarily lead to less price volatility. For example, if Iraq’s invasion of Kuwait implies higher fuel costs and lower profits for airlines, then the price of airline stocks will fall rapidly--regardless of whether there are 10,000 or 5,000 trades per day in airline stocks. Indeed, if the market consensus is that a stock’s price should drop 10 points because of adverse news, that drop will occur in relatively large steps per trade if there are only a few trades that day.

The strongest argument for the 0.5% excise tax is that it would raise $12 billion a year, assuming the level of securities trading in the United States declines only 8%. This may be a heroic assumption in light of the dramatic growth of the Eurobond market, due in part to investors seeking to avoid U.S. taxes on interest derived from bonds issued in the United States.

European stock markets will be boosted by current proposals to eliminate all stock transfer taxes in England and West Germany. Of course, to the extent that securities trading moves offshore, the United States would lose not only the revenue from the 0.5% excise tax but also the revenue from income taxes on securities firms and their employees.

For similar reasons, the proposed capital gains taxes on foreign investors, while politically popular, would be counterproductive. In 1989, foreign investors supplied new U.S. ventures with $300 million in private capital, 13% of the total venture capital committed in that year to new U.S. ventures. That flow of foreign capital would be drastically reduced if the United States imposes a capital gains tax on foreign sales of over 10% of the stock of a U.S. company.

The proposed capital gains tax would threaten the much larger volume of foreign purchases of publicly traded U.S. stocks--from $180 billion to $250 billion per year--because foreign investors can be pushed over the 10% tax trigger by events beyond their control. Under the proposal, every foreign investor would be deemed to own not only its actual U.S. stock holdings, but also the U.S. stock holdings of any individual or entity owning more than 10% of that foreign investor. For instance, a foreign mutual fund owning 9% of the stock of a U.S. company could be deemed to own more than 10% of that company if one of the fund’s large shareholders decided to acquire a large block of shares in that company.

The proposed capital gains tax on foreign investors could have a boomerang effect because U.S. investors do not currently pay capital gains taxes on stock sales in any of the major industrialized countries--Japan, West Germany, Canada, France and England. No other foreign government appears to tax capital gains by U.S. investors unless they control a foreign company. Control in those countries is typically limited to situations where the U.S. investor owns more than 25% of a foreign company.

The strongest argument for this proposal is that it may close a tax loophole used by a few foreign companies owning the controlling shares of U.S. subsidiaries. Because the prices of their shares will increase to reflect the earnings of their U.S. subsidiaries, foreign companies can sell back some of their shares to their U.S. subsidiaries for nontaxable capital gains, instead of receiving the earnings of those subsidiaries in the form of taxable cash dividends on their shares.

But these private sale-backs have nothing to do with foreign trading of U.S. stocks on the New York Stock Exchange, and this tax loophole could be closed by a narrow restriction on parent-subsidiary transactions that would not discourage foreign investments in U.S. ventures and encourage retaliatory measures against U.S. investors.

Congress could require that the capital gains of foreigners in U.S. stocks be taxed on a reciprocal basis--to the same extent that capital gains of U.S. investors in foreign stocks are taxed by the relevant foreign country. Alternatively, Congress could apply the U.S. capital gains tax to sales by a foreign investor--aggregated together with only its majority shareholder--of more than 25% of the stock of a U.S. company.

Congress ought to think twice before taking out its frustration with the budget deficit by imposing these two taxes on securities transactions. These taxes would reduce the flow of foreign investments in U.S. companies and shift securities trading from the United States to Europe.