Tobin taxes and audit reform

The blizzard from Brussels

The Economist | LONDON

THE Europeans can rouse themselves occasionally. Two initiatives emerged from the European Commission this week, one to improve the audit profession, the other to tax financial transactions. The first raises serious questions about how best to protect investors; the second serious questions about policymakers’ priorities.

Auditing first. A leaked proposal from the directorate-general for the European Union’s single market suggests that Michel Barnier, the commissioner in charge, thinks the industry needs reform from top to bottom. The proposal envisages forcing clients to change auditors every so often, so beancounters and bosses do not get too cosy (although the evidence on whether this helps is weak). It also wants two auditors to work together on the accounts of especially important companies.

But by far the most radical proposal in the leaked draft would be to forbid audit firms from providing non-audit services. In America providing most non-audit services to audit clients is already forbidden, under the Sarbanes-Oxley financial reform passed in the wake of the meltdown of Enron, an energy-trading company. In some European jurisdictions, selling both audit and (say) consulting to a client is still permissible. Mr Barnier’s leaked proposal would not simply go down the route of Sarbanes-Oxley and forbid this. It would force the creation of pure audit firms.

This would be a huge change to the business model of the “big four” audit firms: PwC, Deloitte Touche Tohmatsu, Ernst & Young and KPMG. These are technically networks of firms, rather than single global entities. All of them have seen robust growth in their consulting businesses in recent years, to around a third of total revenues for most of them. In the year ending in May 2011, for example, Deloitte’s consulting business grew by 14.9%, against 4.7% for the audit business. Forcing the breakout of pure audit firms would separate an exciting and growing business from a plodding but vital one, in Europe at least.

Mr Barnier’s proposals are still in draft form, and may change before their formal unveiling in November. After that, the EU’s Council of Ministers as well as the European Parliament will take a crack at modifying them. But in taking on concerns that auditors are not performing their crucial function in public markets as well as they might, the commission deserves credit.

Kind words are far harder to find for the commission’s other big idea. On September 28th it formally proposed a financial-transactions tax (FTT), otherwise known as a Tobin tax—after James Tobin, a Nobel economics laureate who put forward a similar scheme for currency markets in 1972—or a Robin Hood tax by those who want to use the proceeds for aid purposes.

If adopted, the levy would be applied from January 2014: all securities transactions involving an EU-based financial institution would be taxed at 0.1% and all over-the-counter derivatives deals at 0.01% of the notional principal amount. There are several exemptions, including primary equity and bond issues, spot foreign-exchange deals and deals involving central clearing-houses. Retail products such as mortgages will also be exempt. But the commission thinks that the proposal would still capture around 85% of all inter-dealer transactions in Europe, raising an estimated €55 billion ($75 billion) for EU and national coffers.

The big flaw in the plan is that taxable transactions are likely to migrate outside the EU. Although the commission bills its proposals as the first step towards a global agreement, it is hard to discern sweeping international enthusiasm for the idea. The commission’s own numbers, partly based on an unhappy Swedish experiment with an FTT from 1984-91, suggest that derivatives traders could relocate as much as 90% of their business outside any tax zone.

That gives Britain in particular, as the home of Europe’s dominant financial centre, little incentive to adopt the plan (which requires unanimous support). Indeed, euro-zone ministers have said they may just press ahead with their own FTT if they cannot win EU-wide agreement—which could mean extra business for London from the likes of Frankfurt and Paris if Britain vetoes the idea.

Die-hards may not care. They argue that an FTT is a fair way of recouping some of the costs of bailing out financial institutions during the past three years. They also believe that it would be no great loss if the tax drives away “high-frequency traders”, ultra-fast automated traders whose margins are razor-thin. But that assumes the FTT will not simply be passed on to end-customers, either directly by affected institutions or as reduced liquidity leads to wider bid-ask spreads. The commission’s own assessment suggests that the FTT could reduce long-run GDP in Europe by anywhere from 0.5% to 1.8%. At a time of economic frailty, that seems perverse.