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

1. Reframing the Debate: A Revenue, Not a Spending, Problem Dr. William Barclay Chicago Political Economy Group Testimony to Illinois Legislative Pension Committee Hearing July 8, 2013

2. Dr. William Barclay - Background • Worked 22 years at Chicago exchanges • MidAmerica Commodity Exchange, CBOT, CBOE and Chicago Stock Exchange • Responsibilities included: • Product development • Strategic planning • Market research • Worked with: • Exchange staff • Members (individual and institutions) • Regulators: CFTC and SEC • Occasional trader of derivative products • Founding member Chicago Political Economy Group (CPEG) Dr. William Barclay, CPEG

3. Financial Transaction Tax

4. A Revenue Source • What do Switzerland, Australia, Hong Kong and Singapore have in common? • They are all ranked in the top 5 countries on the Heritage Foundation’s “Index of Economic Freedom.” • They also all have a financial transaction tax (FTT). • FTTs are, therefore: • Not an unusual tax. • Not a threat to successful financial markets. • Keynes, James Tobin and Larry Summers have all advocated FTTs – as did Pope Benedict XVI. Dr. William Barclay, CPEG

5. FTTs Around the World Dr. William Barclay, CPEG

6. 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. Dr. William Barclay, CPEG

7. A Very Modest CPEG Proposal: An Illinois FTT of $1/Contract • An FTT on derivative contracts traded on Chicago derivative exchanges (CME* and CBOE) • Derivatives have both a buyer and a seller • Both would pay the $1/contract FTT • Even on the smallest contracts, this $1 is de minimus when compared to the underlying or notional value of the contract • E.g., Corn futures – roughly a $30,000 contract • A $1 FTT would be less than 0.0033% of contract value (1/3rd of a basis point) • On larger contracts a dollar would represent even less, e.g., on the Eurodollar futures, a $1 fee on a $1,000,000 contract (0.00010% ) * CME owns the Chicago Board of Trade Dr. William Barclay, CPEG

8. What Instruments Would Have an FTT? • Chicago Board Options Exchange (CBOE): • Stock index options (on S&P 500, Dow, NASDAQ, etc); • Exclude options on individual stocks (size and competition) • Chicago Mercantile Exchange (CME) • Stock index futures and futures options (S&P 500, Dow, NASDAQ, etc.) • Futures and futures options on interest rates products (T-bonds, T-Notes, Eurodollars, etc.) • Futures and futures options on currencies (Euro, UK pound, yen, etc.). • Futures and futures options on commodities (corn, wheat, soybeans, hogs, cattle, etc.) Dr. William Barclay, CPEG

9. How Much Revenue Could a $1/contract FFT Raise? $6.1 $5.2 $4.6 Dr. William Barclay, CPEG

10. All Taxes Face Counter Arguments • The most common one is: “The exchanges will move out of state.” • Another common one is: “Traders will take their business elsewhere.” • Yet another one is: “The tax could be easily evaded and/or costly to collect.” • Let’s consider each in turn by looking at the economic arithmetic of an FTT (the incentives involved). Dr. William Barclay, CPEG

11. The Economic Arithmetic of an FTT: Exchanges • The relevant question: Have exchanges moved when FTTs were implemented? • No – this has not occurred. • Why? • The tax is not paid by the exchange. There is no economic incentive for the exchange to move. • An FTT is levied on the act of trading. • The exchange simply functions as the collection agency for an FTT. Dr. William Barclay, CPEG

12. The Economic Arithmetic of an FTT for Traders: I • 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. Dr. William Barclay, CPEG

13. The Economic Arithmetic of an FTT for Traders: II • Consider this economic arithmetic from the perspective of a trader (hedger, e.g., farmer, portfolio manager) or a speculator: • If the $1/contract FTT was levied, the trader would give up a fraction of the smallest first and last price change: • $1 of $6.25, $12.50 or $15.625 ($25 on the big S&P 500 Index futures) • What kind of trading strategy or trader is looking for price changes less than the smallest amount a contract can change in value? • Another way of thinking about this: The $1/contract FTT is significantly less than the difference between the bid and ask prices for these contracts. • The economic incentive for a trader to move is very limited. Dr. William Barclay, CPEG

14. The Economic Arithmetic of an FTT for Traders: III • The relevant question: To where would traders go? • Some products trade under exclusive licenses. • These include almost all stock index products. • Derivative exchange competition is not primarily product based. • Very few identical products are listed on different derivative exchanges. • This may reflect 1980s/early 1990s competition in FX and petroleum products. • Consistent outcome: one exchange won all the volume. • It also reflects the problem of liquidity creation in derivatives trading. Dr. William Barclay, CPEG

15. Administering an FTT • The argument that an FTT would be easy to evade/costly to administer also has little merit. • Clearing houses match and clear all trades (CME’s Clearing House and OCC for CBOE). • The CH already serves as a collection agency for transaction fees. • The CH could easily collect an FTT. • Thus an FTT is very low cost to administer and difficult to evade. Dr. William Barclay, CPEG

16. Who Would Pay the FTT? • 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 Dr. William Barclay, CPEG

17. FFT: A Tax for the People, Not on the People • What is good tax policy: • A good tax should be a small amount for any single event. • A good tax should fall on those able to bear the tax. • A good tax should tax activity that we want to limit or discourage. • Lord Adair Turner – much of what goes on in finance is “socially useless” activity. • A good tax should further economic or social justice. Dr. William Barclay, CPEG

18. An FTT is Good Tax Policy • A $1/contract FTT meets the criteria for a good tax: • The FFT rate is very low compared to the value of a contract. • Total notional value of trading on the CME in 2012 was $806 trillion. • The FFT would fall primarily on high income individuals and wealthy institutions. • The FFT would probably discourage some “socially useless” short term trading. • An FFT taxes the sector that caused the financial crisis that led to the Great Recession. Dr. William Barclay, CPEG

19. “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” - John Maynard Keynes Dr. William Barclay, CPEG

20. A Graduated Income Tax Raising Revenue from Those Who Can Afford It

21. Taxes in Illinois • Some claim Illinois is a high tax state. • That depends on where your household falls in the income continuum. • Consider all major taxes: income, property and sales taxes. • IL bottom quintile households pay taxes at the 2nd highest rate in the US. • Middle income quintile households pay taxes at the 5th highest rate in the US. • However, top 1% income households pay taxes at the only the 30th highest rate in the US. • The next 4% of households by income pay taxes at only the 15th highest rate in the US. • A graduated income tax would help remedy this unfair distribution of taxation. Dr. William Barclay, CPEG

22. 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. Dr. William Barclay, CPEG

23. 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. Dr. William Barclay, CPEG

24. Raising Revenue by Closing Tax Loopholes A Summary of Dr. Ron Baiman’s July 3, 2013, Testimony

25. Six Large IL Tax Loopholes • CME’s tax reduction - $85 million • Foreign dividend exclusion - $386 million • Domestic production credit - $200 million • IL would join 22 other states in decoupling • On line hotel room purchases - $25 million • Offshore oil drilling - $75 million • Many other states tax the income share that can be apportioned to their state • Retailer’s discount - $109 million • Flows largely to out-of-state retail chains such as WalMart • TOTAL: $880 million/year in lost tax revenue Dr. William Barclay, CPEG

26. IL Tax Loopholes vs. Pension Funding Gap • Allocate the $880 million to a dedicated fund. • Use the same CFGA* return and investment assumptions that underlie the $95 billion “pension shortfall.” • Use CFGA same 33 year period. • Net present value of these 6 tax loopholes: $70.5 billion*Commission on Government Forecasting and Accountability Dr. William Barclay, CPEG

27. A Summing Up • Illinois has potential revenue sources. • Illinois can enact legislation that would: • Solve the “pension funding crisis.” • Not take away from teachers, state employees, and others their earned benefits. • Pass constitutional scrutiny. • An FTT is a particularly attractive path. • It is time to act. Dr. William Barclay, CPEG

28. Dr. William Barclay, CPEG