Abstract

Tax policy has significant impact on financial decisions of investors and firms. Certain tax policies, such as transaction tax, can stifle the development of capital markets. New financial products, such as mutual funds and asset-backed securities, will have difficulty in competing against traditional substitutes without proper tax treatment. Thus, a well-developed financial system requires a well-designed tax policy.

Tax policy has significant impact on financial decisions of investors and firms. Certain tax policies, such as transaction tax, can stifle the development of capital markets. New financial products, such as mutual funds and asset-backed securities, will have difficulty in competing against traditional substitutes without proper tax treatment. Thus, a well-developed financial system requires a well-designed tax policy.

The development of the secondary market and an investor base for government securities will be influenced by the tax treatment of the earnings of interest or capital gains on government securities holdings. Similarly, the tax treatment of different financial instruments used in government securities markets and of holders of these instruments, including tax exemptions for government securities, will affect the manner in which government securities markets evolve.

10.1 Introduction

Taxation of financial instruments has significant implications for financial market development. Taxation of capital gains and income from securities affects consumption-saving and investment decisions, influencing the general level of savings, the demand for financial assets, and investment. It also strongly affects the allocation of savings.174 If the effective tax rate is higher for equities than for bonds, corporations would prefer debt financing to share issuance, resulting in a more leveraged corporate capital structure. If the interest from bonds and bank deposits is subject to different tax rates, the competitive relationship between banks and financial institutions dealing in securities is affected. In some countries, favorable tax treatment for long-term savings has led to a rapid growth of pension funds and mutual funds, which has transformed the structure of the financial industry. Pension and mutual funds have become major holders of government securities.

Poorly designed tax policies, prevalent in many developing countries, can be a major impediment to well-functioning financial markets. The absence of an appropriate tax system could stifle the emergence of new financial instruments and financial institutions such as asset-backed securities and mutual funds. The development of robust government securities markets, therefore, is also inhibited by the failure to take the adverse consequences of tax policies properly into account in the setting of tax policy.

The tax treatment of financial instruments has often generated intense policy debate between tax and financial officials, and even within the same government ministry. Authorities responsible for collecting taxes are primarily concerned about protecting the revenue base. Especially in developing countries, tax authorities frequently skew the tax regime to take advantage of a relatively well-institutionalized financial sector from which revenue can be raised with little administrative effort.175 Authorities responsible for the development of financial markets, on the other hand, aim at developing a liquid and integrated capital market and favor a tax system that meets the needs of different market participants and does not severely discourage savings and investment.

Considering the importance of financial markets in the development of the national economy, it is essential to design a tax system that is compatible with financial market development without seriously violating tax principles. Good communication between tax and financial market officials and an awareness by officials of how new financial instruments work will assist in developing a balanced tax system.

Tax neutrality is a desirable tax system objective because it minimizes market distortions and promotes efficiency.176 To achieve tax neutrality, it is important to avoid tax fragmentation, which is the different tax treatment of transactions taking different forms but having the same economic consequences. Tax fragmentation can take place across types of income, participants, instruments, and time. Fragmentation can create serious tax loopholes and tax avoidance opportunities. The introduction of new taxes to deal with the perceived consequences of previous taxes often leads to a more complicated and fragmented tax regime.177

To achieve tax neutrality, the government must equalize effective tax rates across various capital and income structures—between corporate and noncorporate capital, debt and equity finance, and capital invested at home and abroad. While this is not easy to achieve, good tax policy should, nevertheless, seek tax neutrality.

10.2 Tax Treatment of Capital Income

10.2.1 Taxation of Interest: Schedular Versus Integrated Approach

With some exceptions (e.g., Chile, Greece, Iceland, Poland, and Turkey), the majority of countries tax interest income or capital gains from government bonds to achieve fiscal equity between capital income and wage and salary income.

Many countries traditionally have taxed interest from government bonds under the comprehensive income tax (CIT).178 The CIT is an integrated income tax system under which all sources of income (wages, rents, dividends, interest, and profits) earned by the same taxpayer are treated as a single income and taxed at a single (often progressive) rate. Proponents of the CIT maintain that it would, if properly designed, achieve both efficiency and distributive objectives (horizontal and vertical equities).179 For this reason, tax reforms have often converted “schedular” (“compartmentalized”) income tax systems into “integrated” (“comprehensive”) systems.

Among the 30 OECD countries, 18 countries include interest from government securities in the CIT. Six of these countries also incorporate a withholding tax element into the CIT. In Belgium, France, and Portugal, taxpayers have an option between the CIT and a withholding tax on interest from government bonds. In Spain, Switzerland, and the United Kingdom, the withholding tax applied on interest earned on government securities is applied as a credit against the CIT.

In Scandinavian countries (Finland, Norway, and Sweden), interest from government securities like other capital income is taxed under the dual income tax system (progressive tax for labor income and proportional tax for capital income), where interest is taxed at a flat rate, although it constitutes global personal income.180 Non-OECD countries, such as China and the Czech Republic, apply a flat tax rate on interest from bonds.

10.2.2 Withholding Tax181

One notable trend in taxation of interest earnings in general, including on government securities, during the past two decades, is application of a withholding tax and/or a separate flat tax for interest earnings. The motivation for this is the administrative ease associated in raising tax revenue from this source. In four OECD countries (Austria, Finland, Italy, and Japan) and in some non-OECD countries (for example, Brazil, Egypt, and India), interest from government securities is excluded from the CIT but is liable to a final withholding tax.

A withholding tax has been favored in some countries because of its ease of implementation and low compliance cost. In addition, a withholding tax is effective in preventing tax evasion. From the perspective of tax authorities, a withholding tax guarantees a minimum level of taxation, even when taxpayers fail to report interest income in their regular tax returns. It advances the collection of revenue by tax authorities, since the tax is deducted when interest is paid and before income is reported in regular tax returns. In some countries, the act of withholding by the paying agent leaves an administrative track that tax authorities find helpful in detecting unreported sources of income and wealth.

A withholding tax is especially useful and warranted in countries where a central depository and a good reporting system for financial intermediaries are not in place. In some jurisdictions, including Germany, Luxembourg, Switzerland, and the United Kingdom, banking secrecy provisions prohibit tax authorities from obtaining information from financial institutions.182 In such circumstances, tax authorities have had to rely on withholding taxes to detect tax evasion.

A withholding tax has shortcomings, however. First, it may inherently distort horizontal taxation equity in the sense that taxpayers subject to withholding tax may pay a higher proportion of income in taxes than those who earn nonwithholding income.183 Second, a withholding tax is not easily applicable to newer financial instruments such as deep discount bonds and derivatives. Third, it impairs the country’s ability to attract foreign savings if the withholding tax is applied to nonresidents.184

10.2.3 Treatment of Capital Gains

10.2.3.1 Capital Gains Taxation and Bond Washing

Many countries, especially industrial countries, tax realized capital gains from company share transactions, either as ordinary income in comprehensive income taxes or as separate capital gains taxes.185 A smaller number of countries tax capital gains realized from transactions in government securities. If capital gains are not taxed or are taxed at a lower rate than interest income, investors may try to convert interest income into capital gains through “bond washing”—selling bonds just before a coupon payment date and repurchasing them immediately thereafter. To counter such tax avoidance practices, most countries not levying a capital gains tax on bonds have adopted various anti-conversion rules.

10.2.3.2 Tax Treatment of Deep Discount Bonds186

Deep discount bonds are securities issued with a reduced or zero rate of interest. Those with a zero rate of interest are called “zero-coupon bonds.” The yield on deep discount bonds is the difference between the purchase price and the redemption price. A conventional bond can be converted into a series of zero-coupon bonds by stripping.187 In some countries, a capital gains tax—usually at a lower rate than ordinary income tax—is payable on the yield from a deep discount bond. In this case, investors could benefit from differences in the tax treatment of deep discount bonds and conventional bonds.

However, most OECD countries treat the discount on issue as interest income and as accruing over the bond’s life. Thus, the holder of deep discount bonds pays tax on accrued income on a yearly basis.188 In some countries, the discount is taxed on redemption or disposal of the bond, giving a small advantage to the holder.

Unintended distortions may sometimes result when tax legislation does not distinguish taxation of discount instruments from that of conventional bonds, but regards the implicit yields of the discount instruments as interest income rather than capital gains. Taxation of discount bonds may become asymmetrical and non-neutral when negative yields (which might reduce the value of the discount interest below its acquisition cost because of an increase in market yields after the discount instrument was purchased) can neither be considered capital losses nor be offset against positive yields earned by the investor on other assets.189

An additional administrative burden for holders of deep discount instruments is imposed when withholding taxes are declared to be applicable to all implicit yields earned on such instruments.190 If withholding tax is imposed at redemption, the market prices of deep discount bonds should be adjusted to reflect such taxation as they are traded, complicating the trade and limiting the bond’s liquidity. If some market participants are exempt from withholding tax, it is not easy to adjust market prices between two trading parties.

In some jurisdictions, withholding tax is imposed yearly on an accruing discount bond. The purchaser sometimes might be subject to withholding tax on the whole difference between purchase price and issue price, despite the seller not having acquired the bond at the time the bond was issued. This requirement may be in place when it is difficult to know the seller’s purchase price. If the bond is traded frequently, the total amount of withholding could be greater than the total amount of ordinary tax due on the discount.

If the tax treatment of coupon-paying conventional bonds is more favorable than that of zero-coupon bonds, issuers may try to seize the advantages applicable to coupon-paying conventional bonds by issuing them at a low rate (i.e., a coupon-paying deep discount bond). To prevent that possibility, some laws set ceilings for the maximum discount at which a coupon-paying bond can be issued. In the United Kingdom, for example, deep discount is defined as either more than 15 percent of the bond’s redemption amount or 0.5 percent multiplied by the remaining years until redemption.

10.2.4 Accrual Versus Realization in Income Taxation

Particularly for personal income, tax systems do not normally tax interest income and capital gains as they gradually accrue, but only when they are realized—when bond coupons are paid or financial instruments are sold or redeemed. This may produce a so-called “lock-in effect” as investors postpone realizing losses or profits that incur taxes. A lock-in effect may also occur when tax treatment differs between long-term and short-term holding of financial assets. Such tax effects are sometimes compounded by accounting rules that do not require assets to be marked to market, which can affect the liquidity of some public issues. These treatments create deferrals of tax with various related distortions, such as favoring some assets over others or discouraging taxpayers from selling assets.191

To prevent problems such as the lock-in effect and bond washing, some countries have adopted an accrual basis for calculating the tax on interest paid or received. In an accrual system, securities are generally marked to market at the end of each tax year, and any accrued gain or loss (even unrealized) is taken into account for tax purposes.192 In countries with an accrual system, prices are normally quoted “clean,” with accrued income accounted for separately. This also simplifies the calculation of tax liabilities on an accrual basis.

10.2.5 Tax Treatment of Inflation Adjustment of Government Securities

In countries with a relatively high inflation rate and a progressive personal income tax, if the entire nominal interest from bonds is considered taxable income, the real (i.e., inflation-adjusted) after-tax interest for domestic investors may easily become negative, thereby discouraging retail demand for government bonds.

Inflation adjustment and proper measurement of taxable income were major tax policy issues between the mid-1970s and mid-1980s, when high inflation swept the global economy.193 During that period, many countries introduced various methods to reduce taxation of nominal increases in income and in the value of taxable assets. As inflation rates declined considerably thereafter and income tax schedules became flatter, those measures subsequently were discontinued or were no longer relevant in most countries.194

While inflation adjustments in taxation for income and capital gains from government securities may be justified even under moderate inflation, most countries do not apply them because of difficulties in administering such adjustments. Also, compensation in taxation for inflation for government securities may be seen as providing benefits for higher-income citizens who are often holders of such securities, and thus becomes more difficult to support politically. In a few OECD countries (Australia, Ireland, Luxembourg, Spain, and the United Kingdom), however, capital gains on financial assets are indexed for tax purposes.195

Even under moderate inflationary conditions, taxing nominal interest can push up nominal tax rates significantly. In this regard, inflation adjustments are as warranted on interest earnings as on capital gains, yet only a few countries (e.g., Brazil and Mexico) take inflation adjustments on interest earnings into consideration.

Inflation-indexed government securities provide investors with an effective method to guard against inflation risk by offering a nominal return that is adjusted with the inflation rate.196 In countries prone to high inflation, a substantial share of the government bonds consists of inflation-indexed bonds.197 Indexed bonds can be constructed in various ways. Two methods are widely used. The first is to index the principal: only principal is adjusted for changes in a selected price index during the life of the bonds with the coupon (interest) rate remaining fixed. Even though the coupon rate is fixed, nominal coupon payment also changes as principal is adjusted every period. At maturity, the principal repayment is the product of the face value of the bond times the cumulative change in the selected price index. In an alternative scheme, the coupon rate is indexed with the redeemable principal remaining fixed. Thus, all of the compensation for inflation comes through the coupon payment.

Although inflation-indexed bonds guarantee before-tax real returns, taxes re-expose indexed bonds to inflation risk. Because most tax rules do not distinguish nominal yield from real income, an increase in nominal yield due to inflation is subject to income tax and the after-tax returns are lowered. The indexing of the principal, which is the method commonly used in most countries, involves a further tax burden. In most countries, to keep the tax on index-linked government bonds equitable with other conventional bonds, the appreciation of the principal of indexed bonds, although received only at maturity, is taxed every year on an accrual basis. This means that in some inflationary environments, the tax liability for indexed bonds could exceed the principal-adjusted coupon interest income, causing a cash flow problem to taxable investors.198 This problem increases the longer the maturity of the bond. This tax implication limits the demand for long-term inflation-indexed government bonds to tax-exempt investors such as pension funds and life insurance companies.

To solve this tax problem and boost the appeal of indexed government bonds, nominal principal adjustment due to inflation could remain tax exempt.199 Alternatively, nominal adjustments could be taxed on an actual payment basis. However, these treatments would be favorable for inflation-indexed government bonds compared with conventional bonds and thus lead to distortions in the demand for indexed bonds relative to conventional bonds.

10.3 Tax Treatment of Different Financial Instruments

10.3.1 Favorable Tax Treatment of Government Bonds

In some countries, interest from government (and municipal) bonds is not taxed or taxed at lower rates than interest paid on private sector debt. Greece and Turkey, for example, exempt interest from government bonds but tax interest from bank deposits. Italy levies a modest 12.5 percent flat tax on government bond interest, which was tax exempt prior to 1987. In the United States, government savings bonds receive favorable tax treatment, and interest earned on state and local governments issues (municipal bonds) are exempt from federal taxation. Although favorable tax treatment of government securities is being eliminated or reduced in developed countries, it is still regarded as an acceptable and useful policy option in developing countries.

There are various reasons for giving government securities favorable tax treatment.200 The most common seems to be a strong belief that tax-exempt government bonds have a marketing advantage and thereby widen the investor base for government securities. The United States utilizes tax exemption on municipal bonds as a federal subsidy to state and municipal governments.

There is, however, a growing consensus that the disadvantages of favorable tax treatment for government securities outweigh its advantages. First, in a competitive market, interest rate arbitrage will ensure that after-tax rates of return are equalized.201 Second, tax-favored government securities are objectionable from the perspective of efficiency. To the extent that a government mobilizes a larger amount of capital through tax exemption for the securities it issues, it risks crowding out possibly more efficient private sector investment, thus reducing overall welfare.202 Subsidization through tax exemption is also considered less efficient than an explicit budgetary subsidy.203 Favorable tax treatment of government securities also raises questions about fiscal equity since in many instances the high-income group is the beneficiary of such favorable tax treatment, thus distorting distributional equity.

Finally, government securities have some advantages over private sector securities even without favorable tax treatment: they typically are risk free, diverse in maturity, and have a large market. Given these benefits, special tax advantages would give them an unfair competitive edge over private sector debt instruments and equity capital, thereby thwarting the development of the private sector capital market. The capital taxation in Italy, for example, characterized by broad usage of final withholding taxes and favorable treatment of government securities, is cited as an important reason for the country’s poorly developed stock market.204 To promote balanced financial market development, a government should seek to ensure a level playing field, where the government as a borrower competes equitably with private sector issuers.

10.3.2 Tax Treatment of Repurchase Agreements (Repos)

To establish an efficient repo market, the dual features of repos (sale and repurchase of a security or collateralized borrowing) should be clearly and appropriately defined in legal, fiscal, and accounting terms. From a legal perspective, the sale and purchase characterization leads to better protection of the solvent party under most countries’ bankruptcy laws. Otherwise, the solvent party is likely to be a creditor that is subject to a rigid insolvency proceeding. However, given the secured loan character of repos, both the seller and the buyer can enjoy the benefits of repo agreements—raising short-term funds at a cheaper rate than uncollateralized borrowing, and temporarily investing cash for collateral—while avoiding realizing a taxable gain or a transfer of assets on the securities involved.

If a tax law treats repos as separate sale and purchase transactions, both parties are subject to complex tax rules, generating extra transaction costs. In the Republic of Korea, for example, the seller (cash receiver) pays tax at the selling date for interest accrued during his holding period, and the buyer (cash provider) pays tax at the time of redemption for the interest accrued during the repo period. These tax burdens complicate repo transactions and deter market participants from entering into repos.205 (See Box 4.6. in Chapter 4.) In Japan, repos are subject to a three-basis-point transaction tax—a factor considered a deterrent to the development of that country’s repo market.

The tax treatment of coupons (interest payments) maturing during the repo period is singled out as a distinct irritant to market participants. Many countries that characterize repos as a secured loan apply a special treatment called “manufactured payment” on the coupon paid on the securities.206 Under this system, the buyer (cash provider) that actually receives coupon or dividend payments will give to the seller (cash receiver) a “manufactured payment” equal to the coupon or dividend paid. The seller (the beneficial owner of the securities) is thus assured the same coupon or dividend stream as if no repo sale had been made. In France, a repo is legally treated as a sale and a purchase.207 However, the law endows repos with a tax-neutral status, requiring the buyer to transfer the relevant coupon back to the seller. This unique combination of legal and fiscal frameworks—a very secure legal protection of repos and a removal of fiscal impediment—has led to the rapid growth of France’s repo market.

10.4 Taxation of Different Government Securities Holders

10.4.1 Taxation of Nonresident Government Securities Holders

The taxation of income from foreign investments, and of investment abroad by residents, is very complex, as it is subject to interaction between two or more countries’ tax systems and is dependent on specific tax provisions stipulated in both domestic legislation and bilateral tax treaties.

Regarding taxation of international capital flows, a country must choose between the “residence principle,” whereby taxation rights belong to the capital holder’s country of residence, and the “source principle,” whereby these rights belong to the country in which the capital resides. Most countries, following the principles outlined by the OECD Model Tax Convention,208 have double tax avoidance provisions that embody a combination of residence and source principles. In this regime, source countries apply a modest withholding tax to passive capital income, usually lower than the domestic tax rate.209 Nonresidents typically receive credit for this withholding tax in the country of residence. In this way, double taxation is avoided and the tax is shared between the residence and source countries.

In the past two decades, an increasing number of countries have abolished—unilaterally or under tax treaties—withholding taxes on nonresidents. In addition, many countries are facing pressure to eliminate withholding taxes on interest earnings.210 The principal reason for this trend is growing international tax competition to attract the funds of large foreign savings institutions such as pension funds, investment funds, and life insurance companies. Such institutions, often tax-exempt in their home country, are particularly sensitive to source country withholding tax, which they are unable to reclaim in their home country.211 Financial institutions that pay taxes in their home country may recover withholding tax, but administrative delays in this recovery create inconvenience and costs.

The reduction or elimination of withholding taxes on interest on financial instruments, on the other hand, raises a new concern, viz., the growing importance of tax evasion associated with international portfolio investment. Little or no withholding tax in a source country shifts the burden of effective taxation of cross-border capital flows to the residence country, which usually taxes foreign-source income under the personal income tax. With an increasing discrepancy between the withholding tax rate at the source and the corresponding personal income tax rate in the residence country, investors have a strong incentive not to disclose their interest income.212 Furthermore, lack of an effective information exchange framework between the tax authorities of the two countries makes it difficult for a residence country to collect taxes due.

To address this potential tax abuse, proposals have recently appeared in the literature to raise withholding taxes at the source and enhance information exchange among national tax authorities.213 As the present tax system inadequately catches cross-border capital income in the tax net, this alternative approach suggests that current, relatively low withholding taxes should be raised within a broad multilateral framework. This line of thought, although relatively new and requiring elusive multilateral agreements, represents a possible reversal of the trend to eliminate withholding taxes.

10.4.2 Taxation of Collective Investment Funds (CIFs)

The past two decades have witnessed rapid growth of collective investment funds (CIFs) in many countries. (See Annex 6.A in Chapter 6.) Considering the difficulties for individual investors to invest in government securities, CIFs provide an attractive vehicle for such investors, since they offer diversification of risk, quality asset management, and a variety of investment options.

To be competitive with other financial instruments, CIFs should be at least tax neutral; such funds—whether corporate or contractual, open or closed-end—should be no less attractive than the direct investment in the same assets.214 This principle should be particularly observed for the corporate-form CIF. CIFs are sometimes wrongly treated as a regular company, subject to economic double taxation and thereby disadvantaged in relation to trusts and contractual CIFs which are not treated as taxable entities. This is often the case where CIFs are in the early stages of development and when the true nature of a corporate CIF, i.e., a conduit or a paper company for investment purposes, is not fully understood by policymakers.

In addition to securities transaction taxes, CIF earnings are subject to income and capital gains taxes. The International Fiscal Association’s 1997 report identified five generic models for taxation of CIFs under two major fund tax regimes, the U.S. and European.215

The U.S. system of taxing CIFs is called “pass-through.” All dividends and interest received by a CIF from its investments are given in gross form (i.e., no tax is levied at source) and passed through to CIF shareholders; all capital gains are also passed through. Under this system, all shareholders are responsible for their own tax calculation and payment.

Most European tax regimes require a tax deduction at the source (i.e., the payer of dividends or interest). The tax deducted and paid to the tax authorities is converted into a tax credit (as recognition of tax already paid). This credit passes through the CIF without further tax intervention and is available to fund shareholders to offset their own tax liabilities. Since the deduction at the source is normally at the standard rate of personal income tax, most minority shareholders have no additional tax to pay. Only higher-rate taxpayers are subject to additional payments. For those jurisdictions having a personal capital gains tax, the CIF’s shareholders will be subject to the capital gains tax when the shares are sold with gains.

In the U.S. model, tax effects occur at the level of the investor. Thus, this regime requires somewhat more financially sophisticated investors, along with a thorough and efficient tax collection system. The European system collects tax at the level of payer (corporate), and it mostly disregards capital gains so long as they are retained for reinvestment. This system is based on the recognition that taxation at the investor level is both costly and difficult to collect. Developing countries with weak institutional backgrounds may find the European approach appealing for its practicality and simplicity.

10.4.3 Taxation of Pensions

The tax treatment of pensions is important for the development of government securities markets. Contributions to private pension funds are a major source of national private savings, and hence represent an important source for institutional investment in the capital market, including for government securities.216 Thus, policymakers should give careful consideration to designing a tax regime for pensions that is conducive (or at least not detrimental) to capital market development.

Most countries with well-developed pension systems provide favorable tax treatment for saving through pensions. The most common approach is to allow contributions to be deducted from taxable income, allow investment income to accumulate tax free, and tax benefits in full upon withdrawal.217 Under this arrangement, taxes for contributions and investment earnings are deferred until withdrawal. Most tax legislation allows expenditure-tax treatment only for pension funds, while other types of savings are subject to normal income taxation, which leads to enormous accumulations in pension funds.

Besides creating distortions among types of savings, favorable tax treatment of pension funds results in forgone tax revenue; i.e., taxes that would have been collected on contributions and investment earnings, less those paid on benefits.218 In addition, high-income taxpayers benefit more from this preferential treatment. To deal with these effects, most countries with an EET tax regime set maximum limits for tax-deductible contributions.

Some countries, notably Australia and New Zealand, use an alternative taxation approach and tax both contributions into the pension plan and interest income, while allowing exemption of benefits.219 Under this approach, pension savings are subject to the same tax rule applied to ordinary interest-bearing savings—a situation that constrains the development of occupational retirement plans.

In Germany, Japan, and Korea, pension liabilities held on the financial accounts of the sponsoring firms (book reserves) are, to some extent, tax deductible against the firm’s corporate tax obligation.220 For book-reserve plans, firms do not actually contribute to the plan, but each year charge prospective pension liabilities against the firm’s financial statements. Despite alternative pension plans providing equivalent or better tax treatment, book-reserve plans are quite popular in these countries because firms can use money that would have been put into a pension plan as valuable working capital. In this sense, book-reserve plans thwart the development of private pension funds. Also, In the event of insolvency of sponsoring firms, employees are treated the same as other creditors. The vested benefits of employees, thus, could be severely jeopardized under the book-reserve system.

10.5 Tax Incentives for Financial Instruments to Stimulate Savings

Tax incentives for financial instruments to stimulate savings have been criticized for various reasons.221 Such incentives distort relative prices and lead to inefficient resource allocation, they create tax inequity because nonpreferred sectors must bear the heavier tax burden to compensate the government for forgone revenue, they promote unproductive rent-seeking behavior, and they undermine administrative simplicity of a tax system and impose substantial monitoring costs.

Nonetheless, both developed and developing countries have made extensive use of tax incentives for certain financial assets to stimulate private savings.222 Box 10.1. provides a summary of targeted saving programs in selected industrial countries that have tax-saving incentives. Contributions to retirement savings and pensions are tax deductible in most countries; savings with life insurance companies also receive special tax treatment. Moreover, governments are providing various tax-exempt accounts and targeted savings promotion plans, such as the IRA and 401(k) in the United States and the plan d’épargne populaire (PEP) in France.

Empirical work on the relationship between tax incentives and overall saving levels shows mixed results. However, it is generally accepted that tax incentives have a strong impact on the composition of portfolios. In this regard, properly designed tax incentives, when used with care, can be effective in achieving certain economic goals such as the promotion of the long-term bond market. This is especially meaningful for developing countries in which the investors’ time horizon is fairly short and short-term financial instruments dominate the bond market.223

Targeted Saving Incentives in Industrial Countries

401 (k) Plan

A type of defined contribution pension plan covered in Section 401(k) of the Internal Revenue Code of the United States of America. This plan allows employees to contribute pretax dollars to a qualified tax-deferred retirement plan. Employers usually match some of their employees’ contributions to the plan to encourage employees’ participation. Employees like this plan because they can defer income tax liability on the contributed income and their savings grow tax free until retirement. Employers like this plan because it limits the company’s pension liability and shifts the responsibility of investment performance from the company’s pension plan to employees.

Individual Retirement Account (IRA)

A tax-deferred, long-term saving program in the United States. Individuals could make tax-deductible contributions to IRAs limited to $2,000 per year. Filers with income above $40,000 (single) and $60,000 (joint) cannot make tax-deductible contributions, but still could make nondeductible contributions to gain the benefit of tax deferral. Withdrawals from IRAs prior to age 59 and ½ are subject to a 10 percent (of principal) tax penalty.

PEP

The tax-exempt individual savings plan (plan d’épargne populaire) offered since 1990 by banks and insurance companies in France. The duration of a PEP should be longer than eight years to be eligible for the tax exemption. At the end of a PEP, the subscriber can choose either the use of the tax-free lump sum capital or the payment of an annuity exempted from any income tax.

Personal Equity Plans (PEPs)

A policy measure introduced in 1986 to encourage wider share ownership in the United Kingdom. Investors in PEPs are exempt from income tax on dividends arising from stocks held in a plan. In addition, there is no capital gains tax when stocks are sold. In January 1992, PEPs were split into two subplans—the “single-company PEP” and the “general PEP.”

RRSP/RPP

The Canadian tax-deferred retirement savings program. Registered pension plans (RPPs) are occupational pension plans where contributions are deductible, income accrues tax free, and pension income is taxed when it is received. Registered retirement savings plans (RRSPs) are individual accounts similar to IRAs in the United States. The two systems have been implemented as an integrated system in terms of contribution limits. The RRSP is a more flexible system in which investors have great discretion over the types of assets they choose to hold and the methods of cashing out the funds. RRSP investors may either withdraw all of the funds at any point and include them in taxable income that year or purchase an annuity prior to their 71st birthday.

Vermoegensbildungsgesetz (Wealth Accumulation Program)

A German saving program introduced in 1961 in an attempt to partially equalize wealth distribution. Employees authorize the deduction of a certain amount of their salary, which is directly deposited into long-term (at least six-year) funds. Both the employer and the employee can make contributions. If the employee’s income falls short of a certain limit, the government supplements the contributions at a fixed percentage until an upper limit is reached. Funds eligible for a subsidy include shares in the employee’s own or any other company and savings at building societies.

Sources: NBER (1994) and Downes and Goodman 1998

If governments want to keep the effect of tax incentives to promote savings neutral as far as the choice of type of investment asset is concerned, the best way is to establish tax-favored savings accounts, which may be invested in any class of asset—certificate of deposit, bond, or equity shares. The choice of asset class would depend on the individual’s risk preference, and would not be directed to any particular asset class because of tax considerations.

Where governments do use tax incentives, such measures should satisfy two basic criteria.224 First, they should achieve their stated objectives. Second, they should be the most efficient means to achieve those objectives. It is not unusual to find tax incentives that fail to meet even the first basic criterion. With regard to the second criterion, only few tax incentives qualify. In designing tax incentives, tax authorities should, therefore, set clear policy objectives and rigorously check whether a tax incentive is the best means to achieve the set goals.

If a government manages tax incentives in an ad hoc and inconsistent manner, such incentives are subject to proliferate over time. If tax incentives are based on pressure from the business community on noneconomic considerations, other interest groups will also request special tax treatment. The tax system then will become more complex and inefficient. A sunset clause for tax incentives is a useful device against such proliferation by requiring policymakers to periodically review the efficacy and justification of tax incentives.

10.6 Transaction Taxes on Financial Instruments

Transaction taxes (especially stamp duties) have a long history in some countries, and many countries still rely on various types of transaction taxes.225 Equities are typically subject to higher transaction taxes than bonds and derivatives. Government bonds are usually exempt from transaction taxes. However, as financial innovation provides various close untaxed substitutes (including offshore transactions) the efficacy of transaction taxes has been eroded substantially. In addition, growing competition among international financial markets has put downward pressure on transaction costs. Consequently, during the past decade, several major countries have lowered transaction tax rates or removed transaction taxes altogether.

Given the high volume of financial transactions, many policymakers consider financial transaction taxes as a potent revenue source even at low tax rates.226 Numerous discussions in the 1990s over securities transaction taxes (STT), especially in the United States, have been against a backdrop of this primary motive as a tax revenue source.227 However, the revenue potential of transaction taxes could be significantly reduced by responses of market participants that lead to decreased transaction volume. In particular, transaction taxes on derivatives or short-term money market instruments could be harmful to markets that are characterized as high volume and low margins, resulting in severe contraction of trading with little tax revenue. Thus, static estimation of potential tax revenue from the imposition of transaction taxes based only on the current trading volume could turn out to be disappointing.

Some prominent economists, who maintain that financial markets absorb too many resources relative to their social benefits, have proposed transactions taxes to reduce excessive speculation by “putting sand in the wheels” of financial markets and thereby increase market efficiency.228, 229 This proposal, however, has encountered heavy criticism from both academic circles and financial communities. Opponents argue that transaction taxes decrease the efficiency of financial markets by reducing liquidity and increasing transaction costs.230 They also claim that transaction taxes increase the cost of capital, which could lead to lower rates of investment and output growth.

10.7 Conclusion

A tax system is inherently rigid. Once a tax rule is embedded in asset prices and creates associated interest groups, attempts to change it can become mired in political struggle. Furthermore, there are revenue consequences to any change. Tax authorities are generally reluctant to forgo existing sources of revenue unless forced to do so, which suggests that policymakers should make the extra effort to design an appropriate tax system, and should consider the possible adverse effects that a change might have on financial market development on a par with the revenue implications. For a balanced decision, close dialogue between tax and financial authorities is essential. A decision driven mainly by a myopic revenue objective is likely to unduly repress financial market development, including the market for government securities.

The taxation of earnings on government securities and any capital gains derived from transactions of government securities will influence savings and investment decisions in general, and, in turn, affect the development of the government securities market. An appropriate taxation system for interest earnings and capital income on government securities should be based on the three fundamental tax principles: tax neutrality, simplicity, and fairness. A tax system should collect tax revenue from interest earnings and capital income from government securities with the least distortions possible on the savings decisions of taxpayers. Although tax neutrality is a laudable objective, no tax system fully satisfies this principle. In designing a new tax regime or a tax reform strategy, tax authorities should properly assess the country’s administrative capability and compliance costs to the public. It is sensible for developing countries to take an evolutionary approach: first, start with a simple tax system that requires little administrative resources and as the institutional infrastructure builds up, gradually transform the tax system toward a more sophisticated and neutral tax regime.

Finally, to achieve better efficiency and equity in taxation of interest earnings and capital income from government securities, two tax measures—favorable tax treatment of government securities and imposition of an array of securities transaction taxes—which are established in many countries and tempting to many policymakers, should be critically reviewed. It is difficult to find a convincing theoretical rationale for tax-exempt government securities. Poor institutional frameworks in developing countries could be a practical excuse for tax exemption of interest income altogether. However, so long as minimal tax collecting is feasible, tax authorities should consider introducing a tax system applicable to the earnings on government securities at terms that are comparable to other taxable income sources that can be administered with ease. A withholding tax could be a good stepping stone in this regard. With regard to securities transaction taxes, there is strong inertia to maintain existing transaction taxes or even attempt to introduce new transaction taxes when financial markets grow fast. However, in order to develop liquid and active government securities markets, governments would be well advised to eliminate securities transaction taxes.

Bibliography

  • Alworth, Julian S. 1998. “Taxation and the Globalization of Financial Markets.” In P. Roberti, ed., Financial Markets and Capital Income Taxation in a Global Economy. Amsterdam and New York: Elsevier.

    • Search Google Scholar
    • Export Citation
  • Bainton, Lyndsey. 1995. “The New U.K. Tax Regime for Repurchase Agreements.” International Financial Law Review 14 (9): 4344.

  • Bargella, M., and Laura Castellucci. 1998. “Capital Movements, Real Interest Differentials, and Taxation: Theoretical Issues and Recent Developments in Italy (1982–1994).” In P. Roberti, ed., Financial Markets and Capital Income Taxation in a Global Economy. Amsterdam and New York: Elsevier.

    • Search Google Scholar
    • Export Citation
  • Burman, Leonard E. 1999. The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed. Washington, D.C.: The Brookings Institution Press.

    • Search Google Scholar
    • Export Citation
  • Casson, Peter C. 1998. “International Aspects of the U.K. Imputation System of Corporate Taxation.” British Tax Review 5: 493507.

    • Search Google Scholar
    • Export Citation
  • Catalyst Institute. 1995. Securities Transaction Taxes: False Hopes and Unintended Consequences. Suzanne Hammond, ed. Burr Ridge, Illinois: Irwin.

    • Search Google Scholar
    • Export Citation
  • Chua, Dale. 1995. “Tax Incentives.” In P. Shome, ed., Tax Policy Handbook. International Monetary Fund, Washington, D.C.

  • Cnossen, Sijbren. 2000. Taxing Capital Income in the European Union: Issues and Options for Reform. Oxford and New York: Oxford University Press.

    • Search Google Scholar
    • Export Citation
  • Davis, E. P. 1995. Pension Funds. Oxford and New York: Oxford University Press.

  • Dilnot, Andrew. 1992. “Taxation and Private Pensions: Costs and Consequences.” In Private Pensions and Public Policy. Organization for Economic Cooperation and Development, Paris, France.

    • Search Google Scholar
    • Export Citation
  • Downes, John, and Jordan Elliot Goodman. 1998. Dictionary of Finance and Investment Terms (5th ed.). Hauppaug, N.Y.: Barron’s Educational Series, Inc.

    • Search Google Scholar
    • Export Citation
  • Financial Times. 1997. “Repos and Strips.” Financial Times Survey, Supplement (December 5), 16.

  • Gravelle, Jane G. 1994. The Economic Effects of Taxing Capital Income. Cambridge, Mass.: MIT Press.

  • Harris, Peter A. 1997. “Neutralizing the Imputation Systems.” italic>Asia-Pacific Tax Bulletin. Vol. 3 (June).

  • Hubbard, R. Glenn. 1995. “Securities Transactions Taxes: Can They Raise Revenue?” In Suzanne Hammond, ed., Securities Transaction Taxes: False Hopes and Unintended Consequences. Burr Ridge, Illinois: Irwin.

    • Search Google Scholar
    • Export Citation
  • Institute for Fiscal Studies. 1989. Neutrality in the Taxation of Savings: An Extended Role for PEPs.

  • International Fiscal Association. 1997. “The Taxation of Investment Funds.” In Studies on International Fiscal Law. 51st Congress of the International Fiscal Association, Vol. 82b.

    • Search Google Scholar
    • Export Citation
  • Kopcke, R. W., and R. C. Kimball. 1999. “Inflation-Indexed Bonds: The Dog that Didn’t Bark.” New England Economic Review. January/February, Federal Reserve Bank of Boston, Boston, Mass. Available at www.bos.frb.org/.

    • Search Google Scholar
    • Export Citation
  • Messere, Ken. 1999. “Half a Century of Changes in Taxation.” Bulletin for International Fiscal Documentation. 53 (8/9).

  • Mouy, Stephane, and Edward J. Nalbantian. 1995. “Repurchase Transactions in the Cross-Border Arena.” International Financial Law Review 14 (3): 1519.

    • Search Google Scholar
    • Export Citation
  • NBER (National Bureau of Economic Research). 1994. Public Policies and Household Saving. James M. Poterba, ed. Chicago and London: University of Chicago Press.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Norregaard, John. 1997. “The Tax Treatment of Government Bonds.” Tax Notes International, Vol. 15.

  • OECD (Organization for Economic Cooperation and Development). 1994a. Taxation and Household Saving. Paris, France.

  • OECD (Organization for Economic Cooperation and Development). 1994b. Taxation of New Financial Instruments. Paris, France.

  • OECD (Organization for Economic Cooperation and Development). 1999. Taxation of New Cross-Border Portfolio Investment: Mutual Funds and Possible Tax Distortions. Paris, France.

    • Search Google Scholar
    • Export Citation
  • OECD (Organization for Economic Cooperation and Development). 2000a. Model Tax Convention on Income and on Capital: 2000 Edition. Paris, France.

    • Search Google Scholar
    • Export Citation
  • OECD (Organization for Economic Cooperation and Development). 2000b. Model Tax Convention on Income and Capital: Condensed Version, 2000. Paris, France.

    • Search Google Scholar
    • Export Citation
  • Price, Robert. 1997. “The Rationale and Design of Inflation-Indexed Bonds.” IMF Working Paper 97/12. International Monetary Fund, Washington, D.C. Available at www.imf.org.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Plasschaert, Sylvain R. F. 1988. Schedular, Global and Dualistic Patterns of Income Taxation. International Bureau of Fiscal Documentation, Amsterdam, the Netherlands.

    • Search Google Scholar
    • Export Citation
  • Raffer, K. 1998. “The Tobin Tax: Reviving a Discussion.” World Development 26 (3).

  • Shah, Anwar. 1995. Fiscal Incentives for Investment and Innovation. Oxford and New York: Oxford University Press.

  • Shome, P., and Janet G. Stotsky. 1996. “Financial Transactions Taxes.” Tax Notes International. January.

  • Spahn, Paul B. 1995. “International Financial Flows and Transaction Taxes: Survey and Options.” IMF Working Paper 95/60. International Monetary Fund, Washington, D.C. Available at www.imf.org.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • St. Giles, Mark. 1999. The Taxation of CIFs and Their Investors. Processed.

  • Stiglitz, Joseph E. 1989. “Using Tax Policy to Curb Speculative Short-Term Trading.” Journal of Financial Services Research. December.

  • Summers, Lawrence H., and Victoria P. Summers. 1989. “When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax.” Journal of Financial Services Research. December.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito. 1980. Inflation and the Personal Income Tax. Cambridge, U.K.: Cambridge University Press.

  • Tanzi, Vito, and John King. 1995. “The Taxation of Financial Assets: A Survey of Issues and Country Experience.” IMF Working Paper 95/46. International Monetary Fund, Washington, D.C. Available at www.imf.org.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito, and Howell H. Zee. 1998. “Taxation in a Borderless World: The Role of Information Exchange.” In B. Wilman, ed., International Studies in Taxation. The Hague, the Netherlands: Kluwer Law International.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito, and Howell H. Zee. 2000. “Tax Policy for Emerging Markets: Developing Countries.” National Tax Journal. July.

  • Tobin, James. 1984. “On the Efficiency of the Financial System.” Lloyds Bank Review. July.

  • U.S. Treasury Department. 1992. Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once. Washington, D.C.: Government Printing Office.

    • Search Google Scholar
    • Export Citation
  • Zee, Howell H. 1997. “A Note on the Nonneutral Taxation of Indexed Government Bonds Under Alternative Indexation Schemes.” Economic Letters, Vol. 56.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Zee, Howell H. 1998. “Taxation of Financial Capital in a Globalized Environment: The Role of Withholding Taxes.” National Tax Journal 51.

    • Search Google Scholar
    • Export Citation
  • Zee, Howell H. 2000. “Sending Short-Term Capital Inflows Through Withholding Tax.” Tax Notes International. July.

175.

Transaction taxes on financial transactions have been viewed by tax authorities as a convenient way to collect taxes from the financial sector.

176.

Tax neutrality requires that taxpayers’ economic decisions should not be affected by imposition of a tax. In relation to savings decisions, tax neutrality requires that the choice of where to save (the allocation of savings), when to save (the timing of savings), and how much to save (the amount of savings) be independent of all taxes.

177.

The introduction of new taxes to deal with the perceived consequences of previous taxes has been the practice in the United States, the United Kingdom, and other common law countries.

179.

Full realization of a CIT is not easy to attain. To achieve full tax neutrality, accrued income from intermediated savings (e.g., pension funds and life insurance companies) should be attributed to individuals, which can be difficult to calculate. The merits and limitations of the CIT are addressed in OECD 1994a.

180.

Cnossen (2000) analyzes the tax reforms in Scandinavian countries. According to Cnossen, conversion to the dual income tax (DIT) can transform “nominally comprehensive, but factually concession-riddled income taxes into effectively more comprehensive, if nominally less progressive, DITs.”

181.

A withholding tax is a tax deduction at source (employers for wages and interest-paying financial institutions for interest). One needs to distinguish between two types of withholding taxes: creditable versus final. In the former, the withholding tax is creditable against the final tax liability of taxpayers when they file their taxes after the end of the tax year. For a final withholding tax, the final tax liability of a taxpayer for this source of income is cleared with the withholding or tax deduction at source.

182.

Developing countries suffering from pervasive tax evasion should consider granting tax authorities access to banking secrecy with strict anti-abuse requirements.

183.

It is the final withholding tax that gives rise to possible distortions. The creditable withholding tax is simply a collection device and has no substantive economic consequences.

184.

In Scandinavian countries, nonresidents are exempt from withholding tax.

185.

The taxation of capital gains has become one of the more controversial policy issues. Burman (1999) reviews various policy issues of the capital gains tax within the U.S. context (see also Gravelle 1994 and Cnossen 2000).

186.

OECD (1994b) examines the taxation of new financial instruments, including deep discount bonds.

187.

Stripping involves separately trading registered interest and principal of securities.

188.

In calculating annual accrued income, most countries use a constant interest rate compounded annually. Others do not, recognizing the discount accrued evenly over the bond’s life. The linear approach is less preferable to the holder because the discount will accrue more rapidly under the linear method of calculation than the compounded basis, resulting in a heavier tax burden during the early life of the bond. The linear basis is thus especially detrimental to deep discount bonds with long maturity.

189.

OECD (1994b) shows that if a bond is sold before redemption, the difference between accrued interest at the time of disposal and the disposal proceeds is not regarded as taxable gain or deductible loss in 7 of 24 OECD countries.

191.

In the case of mutual funds, a lock-in effect may significantly limit the willingness of investors to actively manage their portfolios. The mutual fund industry in many countries has recently responded to this problem by offering umbrella funds and other products that allow individual investors to shift funds without being subject to taxation.

192.

New Zealand was one of the first countries to adopt such a policy in 1986. The United Kingdom moved from a realization to an accrual basis in 1995 and thereby significantly changed the substance of its tax system.

193.

Tanzi (1980) offers a comprehensive discussion of inflation adjustment in the context of personal income tax.

196.

Price (1997) offers a comprehensive discussion of inflation-indexed bonds.

197.

The share of indexed bonds in total government debt toward the end of the 1990s varied considerably (Israel 80.2 percent, Australia 29.5 percent, Turkey 24.3 percent, Brazil 19.6 percent, Sweden 12.5 percent, United Kingdom 12.0 percent, Mexico 8.4 percent, United States 0.8 percent, France 0.6 percent, and India 0.2 percent). See Kopcke and Kimball 1999.

198.

Zee (1997) shows that, even though the tax is proportional, the taxation of income from indexing government bonds is not neutral between the principal indexation and coupon rate indexation methods as long as the accretion to principal is taxed on an accrual basis under the principal indexation method.

199.

In the United Kingdom, nominal gains on the face value of the Indexed Gilts from inflation are tax exempt, although capital gains are generally taxable.

200.

The following discussion is drawn mainly from Norregaard 1997.

201.

In a closed economy with a uniform tax rate, t, the interest rate on tax-exempt bonds (re) is lowered by the tax rate until (1–t) × rt is equal to re, where rt is the pretax rate of return.

202.

Norregaard (1997) suggests that policymakers are affected by the fiscal illusion “that the normally lower borrowing costs associated with tax-exempt bonds also reflect overall or effective lower borrowing costs, and thus expand borrowing and public expenditures beyond what otherwise would have occurred.”

205.

This problem has been responsible for the poor development of the domestic repo market in Korea. The Korean government recently committed to revise the tax law to treat repos as secured loans.

206.

The system in the United Kingdom is discussed in Mouy and Nalbantian 1995.

207.

The French government has successfully promoted the domestic repo market in recent years by providing well-balanced legal, accounting, and fiscal frameworks. Financial Times (1997) and Bainton 1995.

209.

Article 11 of the OECD Model Tax Convention imposes a ceiling of a 10 percent tax on interest paid in source countries.

210.

See OECD 1994a, Chapter 7. Alworth (1998) discusses the effects of withholding taxes in Germany, Italy, and the United States.

211.

For this reason, Alworth 1998 proposes that even countries continuing to levy withholding taxes on nonresidents should consider a zero tax rate for selected financial institutions.

212.

For the practical difficulties of taxing international savings flows, see OECD 1994a.

214.

In some jurisdictions, CIFs enjoy a tax advantage relative to the direct investment in securities. However, special savings promotion schemes, such as individual retirement accounts (IRAs) and 401 (k) retirement savings plans in the United States, and individual savings accounts (ISAs) in the United Kingdom, are generally believed to be mote efficient and fiscally equitable (see St. Giles 1999).

215.

International Fiscal Association 1997. The five main generic models of fund taxation are (i) not subject to tax, (ii) subject to tax but wholly exempt, (iii) subject to tax but not the object of tax, (iv) subject to tax and the object of tax with low or zero percent tax, and (v) fully subject to tax and the object of tax with integration at the investor level.

216.

This section is based in part on Dilnot 1992.

217.

This approach is called EET, an acronym for exempt (contribution), exempt (investment income), and tax (benefit). This tax regime ensures tax neutrality for consumption at different points in time.

219.

This approach is called TTE, an acronym for taxed, taxed, exempt. This represents a comprehensive income tax regime and ensures tax neutrality between consumption and saving.

220.

In Germany, contributions are fully tax deductible, with some restrictions; in Japan and Korea, only 40 percent of contributions are deductible.

221.

See Chua 1995. Shah 1995 provides an extensive discussion of the pros and cons of tax incentives.

222.

NBER (1994) analyzes in detail various types of tax incentives in seven industrialized countries.

223.

Tanzi and Zee 2000 argue that most tax incentives in developing countries are cost ineffective and are often a recipe for corruption. However, they find that tax incentives targeted for rectifying market failure (and thus generating significant positive externalities) can be justified in developing countries.

225.

Securities transaction taxes can be defined as any kinds of monetary obligation levied by public organizations on transactions (including issuance) of securities. Many countries impose a stamp duty (tax) on financial documents, including transfer of securities. In addition to the stamp duty, variations of securities transaction taxes include turnover tax, transfer tax, stock exchange tax, trading tax, transaction tax, and SEC fee. Spahn (1995) provides a good summary of financial transaction taxes worldwide.

226.

This is especially the case in developing countries, where financial markets are one of the few organized sectors.

229.

Increased volatility in world financial markets has also spurred interest in levying a transaction tax on short-term capital flows to reduce volatility in foreign exchange and securities markets. The proposal to impose a tax on currency conversion (so-called Tobin tax), first proposed by James Tobin in 1984, has been widely discussed (see Raffer 1998). Along this line, Zee (2000) argues that a withholding tax, being more difficult to evade and administratively simple, is superior to some type of quasi-capital control measures such as a Tobin tax or nonremunerated reserve requirements.

230.

Shome and Stotsky (1996) offer a good explanation of adverse effects of transaction taxes.