President Barack Obama's proposed financial fee on leverage that would apply to large investment management firms as well as other large financial institutions won't enhance market stability as it supposedly is designed to do.
In fact, revenue, and not market stability, likely is the key motive for the fee, and not even immediate revenue, since the proposal has little chance of passing in the Republican-dominated Congress. Rather, Mr. Obama is laying the groundwork for a future Democratic-controlled Congress. As the president's budget proposal states, “There is no sector-specific federal tax applied to financial firms.”
For that reason alone, financial institutions and asset owners should begin to fight the idea now.
Mr. Obama in his federal budget proposal for fiscal year 2016, which will begin Oct. 1, includes a provision for the fee, or tax, on leverage. It would apply a seven-basis-point fee on leverage of investment managers and other financial institutions with worldwide consolidated assets of more than $50 billion. The companies that are the targets of the proposal include U.S. subsidiaries and branches of foreign entities that reach the $50 billion in assets threshold.
The fee is a variation of transaction taxes, which have been designed to reduce excessive risk-taking and enhance financial stability, but which have proved ineffective.
Based on previous experience, such taxes generate neither the expected revenue nor eliminate abuses that put the financial stability at risk. In Sweden, for example, the revenue generated by a tax enacted in the 1980s did not meet expectations and was offset by a loss of capital gains tax revenue as equity investing declined. Sweden abolished the tax in the 1990s. In spite of that experience, 10 countries in the European Union plan to move ahead with a transaction tax, effective Jan. 1, 2016.
The president's budget proposal promises the fee will enhance financial market stability, while raising revenue. “The financial fee is designed to reduce incentives for large financial institutions to leverage,” the budget proposal states.
“Even with the end of "too big to fail,' excessive leverage still creates risks for the broader economy,” the president's proposed budget, “Investing in America's Future,” states. “Alongside capital requirements and other tools that help rein in excessive leverage, a financial fee would improve economic stability by attaching a direct cost to leverage for large firms.”
The leverage fee, if adopted, would raise an estimated $112 billion over 10 years, according to the budget proposal. However, the fee could drive leverage-based strategies to other venues, keeping out of the reach of U.S. taxes.
The fee takes a scattershot approach. It would be imposed on investment managers and other financial institutions whether their leverage is considered small or large or excessive. It taxes big financial firms, but it will impact large and small clients alike. That's because, to the extent U.S institutions actually pay it, it will be passed on to their clients in higher management fees or lower net returns.
A fee like the one the president has proposed serves as a way to raise revenue from a new source to help finance excessive deficit spending. Investment managers and other financial institutions with their huge pools of assets are attractive targets for proposals to raise revenue. The adoption of such a fee would open the door to extending its reach to smaller money managers and financial institutions, and to raising it above seven basis points.
Investment managers and asset owners should challenge the administration on the effectiveness of a leverage fee in taking excessive risk out of the financial system. If the administration believes a particular level of leverage is excessive and poses risk to the stability of the financial market, then it should identify it and seek to put a ceiling on leverage. If it seeks to target excessive leverage, it should identify the investment managers and other financial institutions it believes put the stability of the financial system at risk. On what basis does the administration even know the seven-basis-point fee is enough to deter excessive use of leverage?
Stress to the stability to the financial system is coming more from the extremely low interest-rate policy of the Federal Reserve Board of Governors that is fueling the rise in equity markets beyond conventional fundamental valuation, and from the growing federal debt level, now more than $18 trillion, up from $8 trillion in 2008, the height of the financial crisis.
The leverage fee disregards the legislative and regulatory measures, including provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act — such as the Financial Stability Oversight Council, enacted by Congress since the financial market crisis — all designed to enhance financial market stability. The fee would add little to those efforts, while serving only to raise the costs ultimately to pension funds and other clients of financial institutions. Investment managers and asset owners need to call on the administration to drop the proposal. n