World Student Community for Sustainable Development

by Julian Dautremont-Smith

A Tobin Tax is a small tax on foreign exchange transactions. This paper shows that a Tobin Tax would have the triple benefits of: 1) increased monetary autonomy, 2) greater exchange rate stability, and 3) sizeable revenues to fund international development and environmental protections. The paper examines common arguments against the establishment of a Tobin Tax and finds that, on balance, the expected benefits seem to outweigh the potential costs.

On November 20th 2001, the French National Assembly voted to adopt a small tax of less than 1 percent on all foreign exchange transactions on the condition that the tax be applied by all 15 states of the European Union. France is now the second country in the world (Canada was first) to accept the principle of the tax, known as the Tobin Tax (Agence France Presse, 2001). First proposed by, and named after, Nobel laureate economist James Tobin in 1973, the tax has recently gained the support of members of international civil society as a check on highly mobile and destructive capital flows. Additionally, advocates see the tax as a way to raise large amounts of money for social development. With the European Union as a whole studying the idea at the behest of France and Germany, the Tobin tax is likely to gain increased visibility as the debate heats up (Elliott, 2001). In this paper, I examine the main motivations for the tax, provide and respond to the arguments of those opposed to this tax, and conclude that a Tobin tax in both feasible and desirable. The paper is organized to first present the primary purposes and motivation for the Tobin tax, and second to examine and attempt to refute the various arguments against the tax while in the process describing in more depth the specifics of a Tobin tax.

II. Purpose and Motivation for a Tobin Tax

To discover the motivation that inspires the demand for a Tobin tax, it is helpful to examine the original justification as described by Tobin himself. Tobin (1978) argues that “the basic problem today … is the excessive international-or better, inter-currency-mobility of private financial capital.” As a result of mobile capital flows, he argues: “National economies and national governments are not capable of adjusting to massive movements of funds across the foreign exchanges, without real hardship and without significant sacrifice of the objectives of national economic policy with respect to employment, output, and inflation. Specifically, the mobility of financial capital limits viable differences among national interest rates and thus severely restricts the ability of central banks and governments to pursue monetary and fiscal policies appropriate to their internal economies. Likewise speculation on exchange rates, whether its consequences are vast shifts of official assets and debts or large movements of exchange rates themselves, have serious and frequently painful real internal economic consequences. Domestic policies are relatively powerless to escape them or offset them.”

The two primary justifications for a Tobin tax are thus monetary autonomy and exchange rate stability. Although these concepts are inextricably linked, they are discussed separately for ease of explanation.

Monetary autonomy

According to Tobin (2001) his “principal objective has been to preserve some measure of national monetary autonomy.” He points out that “market arbitrage and speculation tend to keep money-market interest rates (risk-adjusted) the same in every currency throughout the world, preventing a central bank from adjusting its monetary policy to its local economy.” Similarly, Kirshner (1998) comments that “countries face diverse economic conditions and need to tailor their economic policies accordingly.” Unfortunately, he explains, “investors, scanning the globe for the best rates of return, create pressures for conformity across countries’ macro policies” and “nations that deviate from the international norm, even when pursuing policies appropriate for local needs, are ‘punished’ by capital flight.” Likewise, according to Canova (2000), “free portfolio capital flows have also provided an undemocratic check on once-sovereign nation-states to pursue progressive social and economic policies.”

Further, Tobin (1978) points out that “monetary policy becomes, under floating rates, exchange rate policy” because “the stimulus of expansionary monetary policy to domestic demand is limited by the competition of foreign interest rates for mobile funds” and ” thus much-in the limit, all-of the stimulus depends on exchange depreciation and its effects on the trade balance, namely on shifting foreign and domestic demand to home goods and services.” However, “the effects of depreciation on domestic currency prices of internationally traded goods are inflationary” and worse, ” when the export-import balance becomes the strategic component of aggregate demand, one country’s expansionary stimulus is another country’s deflationary shock” (Tobin, 1978).

Exchange Rate Stability

Kirshner (1998) maintains that “economies need some basic price stability to function” but “new technology allows investors to move huge amounts of money almost instantaneously, at very little cost which can, overnight, cause the value of assets, including national currencies, to change significantly.” Indeed, in 1998 over $US1.98 trillion per day changed hands on the international currency market (Halifax, 2001). Moreover, “80% of these transactions … have a round-trip maturity of seven days or less, and can therefore be said to be of a speculative nature” (Willmott et al., 2001). Willmott et al. (2001) note that “although currency speculation enables banks and investors to make multi-million dollar profits, it serves no real long-term economic purpose and can have devastating effects on the economies of developing countries.”

This is because a central bank must buy and sell its own currency on international markets in order to maintain exchange rate stability. Thus, “the bank buys its currency when a glut caused by an investor sell-off threatens to reduce the currencyâ€^TMs value” (Stecher, 1999). Stecher notes that “in the past, a central bankâ€^TMs reserves were sufficient to offset any sell-off or ‘attack.â€^TM” Unfortunately however, according to the Halifax Initiative (2001) “total reserves of all the worldâ€^TMs countries are now less than one dayâ€^TMs trading in foreign exchange markets” and therefore “many countries can no longer defend themselves against speculative attack, effectively surrendering monetary and economic policy sovereignty to private individuals, investment houses and large banks.” In addition, as Stecher (1999) notes, “attempts by individual countries to gain more exchange rate stability through currency pegs or anchors involve increasingly higher costs: it is necessary to accumulate and maintain enormous international reserves in order to intervene in the currency market and to maintain the extremely high local interest rates that attract foreign capital.”

A recent wave of financial crises sweeping the globe has been linked to financial liberalization and the subsequent outflow of speculative capital. Krugman (1998) found that during the 1990s, major currency crises occurred about every 19 months on average (ctd. in Michalos, 2000). Similarly, Felix (1998) notes that: “Nearly three-fourths of the 181 members of the IMF suffered one or more periods of banking crises or ‘significant banking problemsâ€^TM during 1980-95. Banking crises, defined as ‘cases where there were runs or other substantial portfolio shifts, collapses of financial firms or massive government interventionâ€^TM afflicted 36 countries. ‘Significant banking problemsâ€^TM defined as ‘extensive unsoundness short of crisisâ€^TM afflicted another 108 countries.†(ctd. in Michalos, 2000)”

These crises are often set off by what Canova (2000) describes as a “pattern of addiction to inflow followed by sudden outflow” that “has been repeated so often that the phenomenon has been described as a ‘contagion.’” He states, “it is a painful and sad material reality that the increased dependence of developing countries on short-term private capital inflows has all too often been followed by sudden outflows of capital and financial and economic collapse.” Indeed, a 1996 examination of bank crises and balance of payments crises found that, “of the 26 banking crises they studied, 18 were preceded by financial sector liberalization within a five year interval” and “financial liberalizations accurately signaled 71 percent of all balance of payments crises and 67 percent of all banking crises” (Michalos 2000). Canova (1999) describes the phenomena leading to such crises as it occurred with Mexico: “Liberalized capital flows contribute to an overvalued peso, which leads to growing trade deficits. Growing trade deficits, in turn, lead to an eventual sudden outflow of capital and downward pressure on the peso. As a result, the Bank of Mexico engages in foreign exchange market interventions and raises interest rates to stabilize the peso. In the end, the sharply higher interest rates translate into massive job losses, declining incomes, rising bankruptcies, and financial failures. Such a sophisticated analysis is empirically verifiable.”

Similarly with regard to the Asian financial crises, he argues [1]: “Asian developing countries, however, began competing for foreign investment; many of them dismantled controls on short-term capital inflows and became increasingly susceptible to sudden outflows. … When the inevitable sudden outflow of short-term portfolio capital occurred, currencies fell throughout Asia, including Hong Kong, Indonesia, Malaysia, the Philippines, South Korea, and Thailand. The falling currencies threatened the already weak Japanese yen, and placed pressure on the Chinese yuan. Exacerbating the hot money outflows was the dynamic of competitive devaluation of currencies, so destructive during the Great Depression, in which “beggar thy neighbor” currency price wars threw entire regional economies into a downward spiral. As one economist suggested, never before in economic history has such a large part of the world fallen as fast as Asia in the past few years. “

The Halifax Initiative (2001) argues that “the Asian crises demonstrated the extent to which development is undermined by financial instability.” They point out that “when currency values collapsed in the wake of speculative attack, prices skyrocketed, wages fell, companies unable to pay debts denominated in foreign currencies went bankrupt and joblessness soared.” All told, “three decades of poverty reduction and economic growth was wiped out in the region” and “the crisis threw 10 million people into “extreme poverty†(under US$1 a day) and an extra 23.8 million into “poverty†(under US$2 a day)” (Halifax, 2001). Ominously, “no major area of the globe was safe from the threat or the reality of such currency contagion … currency contagion humbled or threatened each country that had liberalized its capital accounts and permitted inflows of short-term private capital flows,” according to Canova (1999).

Worst of all, the outflow often has very little to do with the economic fundamentals of the country in question. Palley (2000) explains how an overvaluation can occur. He states that “asset price bubbles can be rationally self-fulfilling” because if “market participants expect that the future price will be higher, and they will then buy now on anticipation of this higher future price.” Thus, he continues, “‘market beliefs’ become the driving fundamental, and if speculators share and shape this belief they can drive prices away from the level warranted by economic conditions.” The crisis is then set off as investors act as a herd following the lead of others. He maintains that “each individual acts rationally from his or her own standpoint, but collectively they behave as a herd, each following the actions of others for no reason other than the fact that others are doing it” in which case “the ‘behavior of others’ becomes the market fundamental, and the actions of speculators can trigger movements in market prices through random dealings that have no relation to underlying economic conditions.” Michalos (2000) likewise points out that “once a few important currency traders begin to sell a substantial amount of a certain currency, others suspect a devaluation may be coming and rush to sell their own holdings before it occurs … the greater the rush, the sooner and deeper the crisis.”

Tobin (1978) too believes that “in the ideal world of rational expectations, the anthropomorphic personified ‘market’ would base its expectations on informed estimates of equilibrium exchange rates” but “in the absence of any consensus on fundamentals, the markets are dominated-like those for gold, rare paintings, and yes, often equities-by traders in the game of guessing what other traders are going to think.” He therefore “must remain skeptical that the price signals these unanchored markets give are signals that will guide economies to their true comparative advantage, capital to its efficient international allocation, and governments to correct macroeconomic policies.” Halifax Initiative (2001) points out that “because financial markets rely on imperfect information and highly subjective signals, they are subject to boom and bust cycles independent of underlying economic fundamentals.” This implies that “even countries with their economic ‘house in order’ are vulnerable to attack” and that “the threat of financial instability is therefore not limited to the developing countries, though their thin markets make them more vulnerable” (Halifax, 2001).

The Tobin solution

Tobin (1978) sees two possible solutions to the problems detailed above: a common currency with common monetary and fiscal policy among countries or “greater financial segmentation between nations or currency areas, permitting their central banks and governments greater autonomy in policies tailored to their specific economic institutions and objectives.” Given the miniscule likelihood of the former any time in the near future, he “regretfully” recommends the latter in the form of a Tobin tax. Zee puts forth the rationale that “since private sector speculators do not internalize the destabilizing impact on the country of such capital flows in their investment decisions, their actions generate a negative externality – as viewed from the perspective of the country in question – in the classic sense, and would thus call for an equally classic economic remedy, i.e., a Pigouvian tax on the externality-generating activity which, in this case, would be a tax on capital flows into or out of the country, or both.” Along the same lines, Kirshner (1998) says “the unregulated flow of financial capital is a form of economic pollution that is soiling economies around the world.” For him, “the problem is not mobile financial capital itself” but “rather, the problem is the unregulated nature, or “cost-lessness” of contemporary capital movements, which results in greater financial mobility than is optimal from a global societal perspective, because its negative effects are not part of the calculations of its producers.” He therefore argues that “the best way to correct this problem is the traditional solution to market failure: Tax the pollution in order to force producers to consider the full range of its costs so that pursuit of narrow self-interests and the social optimum again converge.”

Such a tax, according to Wahl and Waldow (2001), “renders all currency transactions that speculate on minor exchange rate changes unprofitable, in particular very short run currency investments” (p. 4). Moreover, Tobin (2001) states that “the virtue of the tax is that it hits the most frequent transactors hardest.” Indeed, as Eichengreen et al. (1995) explain, “a half percent tax translates into an annual rate of 4% on a three months’ round trip into a foreign money market, more for shorter round trips” and “this effect that creates room for differences in domestic interest rates, allowing national monetary policies to respond to domestic macroeconomic needs” (pp. 164-165). At the same time, the tax “would be a negligible consideration in long-term portfolio or direct investments in other economies” and “would be too small, relative to ordinary commercial and transportation costs, to have much effect on commodity trade.” They also maintain that if “speculators have shorter horizons and holding periods than market participants engaged in long-term foreign investment and otherwise oriented towards fundamentals” then a Tobin tax should “diminish excess volatility.” Finally, while acknowledging that “some stabilising transactions might also be discouraged” because “fundamentalists alert to long-run opportunities created by speculative vagaries would have to pay the tax too” they maintain that “those benign influences are not now dominant in short runs” because “the markets would not be so volatile if they were” (p. 165).

Furthermore, as Stecher (1999) argues, “If currency transaction taxes reduce exchange rate instability, banks and other financial institutions would be clear losers” and “benefits would shift to other economic actors.” He cites Felix (1995): “Firms engaged in foreign trade and long-term overseas investment will incur lower costs on net because of the reduced need to hedge against exchange volatility; they will be encouraged by more stable exchange rates to do longer term investing and lending, and the tax revenue plus the downsizing of the financial sector will make more resources available for socially productive use. (ctd. in Stecher, 1999)”

In addition, Canova (1999) points out that “United States there is a sizable tax on labor, the Social Security tax, which levies a combined tax of 12.4% on employers and employees” but “there is, however, no comparable tax on capital flows.” Thus, Stecher (1999) is accurate when he argues that the Tobin tax “has the additional advantage of being a levy on a sector that is relatively under-taxed at present.”

It is important at this point to note that a Tobin tax is only one among many possible controls on capital. As Stecher (1999) points out, the “Tobin tax can be combined with several other forms of unilateral control over inflows and outflows.” It is beyond the scope of this paper to examine these other controls, but it is important to recognize that the Tobin tax is a complement to these other capital controls, not as a replacement. Indeed, as Stecher (1999) explains, “a Tobin tax on its own will not stop speculation if a currency is significantly overvalued” and “thus it is not a panacea for all the ills of the financial system.” He argues that “achieving greater foreign exchange market stability also requires changes in the policies that lead to overvaluation in the first place, and complementary national and international controls and regulation on capital flows.”

III. Arguments Against the Tobin Tax and Responses

Tax is to Small to be Effective

Stotsky (1996) explains a major problem of the Tobin tax is that “if imposed at a high rate, the tax would seriously impair the normal operations of financial markets; while if the tax is imposed at a low rate, it would not deter currency traders who expect significant short-term changes in currency values.” Likewise, Davidson (1997) argues that “a small ‘grains of sand’ Tobin tax, like any other small transactions cost, can stop speculation on small movements in the exchange rate” but “any significant change in the exchange rat in the short-run will quickly swamp any ‘grains of sand’ Tobin tax disincentive” (p. 677). Stecher (1999) explains further that “investors who expect a short-term devaluation of as little as 3% or 4% would not be deterred from a speculative transaction by a Tobin tax set at 0.1 to 0.5%” and, “given the scale of recent ‘emerging marketâ€^TM devaluations (50% in Thailand and Indonesia, 40% in Brazil), the tax would be totally irrelevant.” More specifically, Davidson (1997) points out that “if the magnitude of the Tobin tax is 0.5%, then, ceteris paribus, the expected future spot price must increase only by more than 1.1% more than it would have had to increase in the absence of the tax in induce a bullish sentiment” (p. 677). Thus, “even though the negative annual rate of return on a one-day round trip is 365% when there is a 0.5% Tobin tax, any increase in the spot price of more than an additional 1.1% compared to the no tax situation can still spawn significant speculative flows” and “the imposition of a Tobin Tax per se will not significantly stifle even very short run speculation if there is any whiff of a weak currency in the market” (Davidson, 1997, p. 677-678).

In response, I argue first as Stecher (1999) does that “the Tobin tax would reduce pre-crisis speculative short-term flows and thus help avoid the problem of overvalued exchange rates in the first place.” However, I also admit that it is certainly possible that overvalued exchange rates may still occur. Fortunately, Spahn (1996) offers an ingenious yet simple solution that, in my mind, nullifies the above arguments. He suggests “a two-tier structure: a minimal-rate transaction tax and an exchange surcharge that, as an antispeculation device, would be triggered only during periods of exchange rate turbulence and on the basis of well-established quantitative criteria.” In this plan, “the minimal-rate transaction tax would function on a continuing basis and raise substantial, stable revenues without necessarily impairing the normal liquidity function of world financial markets” and “would also serve as a monitoring and controlling device for the exchange surcharge, which would be administered jointly with the transaction tax.” “The exchange surcharge,” he explains, “would be dormant so long as foreign exchange markets were operating normally” and therefore “would not be used to raise revenue,” rather, “it would function as an automatic circuit-breaker whenever speculative attacks against currencies occurred (if they occurred at all under this regime).” In this way, “the two taxes would thus be fully integrated, with the former constituting the operational and computational vehicle for the latter.” By way of explanation, the exchange surcharge is depicted visually below:

Additionally, Spahn proposes that investors “be given the right to recontract, however, because transaction costs could not be known in advance” and suggests that “speculative attacks would become more difficult to carry out because traders would automatically withdraw from markets during periods of large fluctuations in prices.” “Knowing that their profits would disappear if a currency value changed too quickly,” Halifax Initiative (2001) argues also that “speculators would be less inclined to ‘attack’ a currency” and thus “Spahnâ€^TMs ‘circuit breaker’ may never need to be used, as market participants, conscious of the penalty, would limit speculative activity.” Lastly, Halifax Initiative comments that “Spahnâ€^TMs ‘circuit breaker’ tax would be particularly advantageous for small countries with limited currency reserves” since, attempting to defend their currencies many countries “immobilize increasing quantities of capital that could be used for development” but “by using a market mechanism to protect against speculative attack, reserve requirements could be reduced, liberating revenue for development.”

Revenues and Distribution Thereof

As noted by the Halifax Initiative, an “unintended benefit of Tobinâ€^TMs original proposal was the enormous revenue that could be generated by the tax.” Indeed, as noted above, in 1998, the global daily foreign exchange turnover was $US1.98 trillion per day so even a small Tobin tax could generate substantial revenues that “could help eliminate the worst forms of poverty and environmental degradation globally” (Halifax, 2001). Stecher (1999) estimates revenues of $284 billion a year based on a tax rate of 0.2% and assuming that 20% of transactions are exempt from tax, 20% evade the tax, and the volume of currency trade falls 50% due to the impact of the tax. Michalos (2000) provides revenue estimates from Felix and Sau using figures from the 1995 foreign exchange market “running from about $302 billion to $393 billion in 1995 from a 0.25% tax, from about $148 billion to $ 180 billion from a 0.1 % tax, and from about $90 billion to $97 billion from a 0.05%.”

Ultimately, as Spahn (1996) notes, “revenues generated by the Tobin tax would depend on a number of factors, including the tax base, the tax rate, and the volume of exempt trading” and further, “the tax is likely to provoke a significant behavioral response by market participants that is difficult, if not impossible, to assess.” In recognizance of this behavioral shift, Stecher (1999) points out a “trade-off between the aims of stabilisation and development funding — the more successful the tax as a deterrent to speculation, the less revenue it generates.” But, Stecher also notes that “even if currency trading diminishes radically, the revenue is still very significant.” Also with regard to the impact of this behavioral response on the revenues raised, Palley (2000) argues that in any case, “the tax still remains justified” because “if the impact is small, this implies the demand for currency transactions is relatively inelastic, and the theory of optimal public finance tells us that governments should tax exactly this type of activity” but “if the impact is large, then speculation will have been reduced, thereby reducing the negative externality imposed by speculators on other investors in accordance with Pigouvian tax theory.”

Stotsky (1996) argues that “the allocation of revenues from the tax would be contentious.” Indeed, most advocates of the tax recognize, as do Willmott et al. (2001), that “the most controversial and difficult part of establishing the system for international implementation of the tax will be deciding how the tax should be collected at the international level and then distributed.” However, advocates rightly point out that although distribution might “involve a tough political struggle, no argument against the tax can be constructed from this” since after all, “the tax has to be accomplished before the expenditure has a chance to become a problem at all” (Wahl and Waldo, 2001, p. 11). In any case, for the sake of argument, some plausible suggestions on how revenue might best be distributed are presented below to show that this is certainly no shortage of workable ideas on the subject.

As Wahl and Waldo (2001) explain, there are 3 general options for distributing the revenue:

* national expenditure in the country of the revenue’s origin
* international expenditure
* a mixture of national and international expenditure (p. 10)

Tobin (2001) himself, noting that revenue generation “was never my primary purpose,” expects “each national government to levy and collect the agreed tax by its regular procedures and to decide for itself what to do with the revenues, which might provide inducements to participate.” However, as Spahn (1996) argues, “redistribution to the countries where the tax revenues originated would favor countries with important financialcenters and would be inequitable.” Indeed, “[u]sing Felix and Sau’sestimatesfor the annual revenue from a 0.05% tax applied to 1995 foreign currency exchange volumes, the distribution in billions of U.S. dollars would have been as follows: (Industrial Countries) UnitedKingdom 28.7 billion, United States 15.1, Japan 9.9, Switzerland 5.3, Germany 4.5, France 3.6, Australia 2.4, Denmark 1.8, Canada 1.7, Netherlands 1.4, Sweden 1.2, Other OECD countries 8.1, (Developing Countries) Singapore 6.4, Hong Kong 5.5, South Africa 0.3, Bahrain 0.1, Other LDCs 1.1″ (Michalos, 2000). Finally, this option also misses the great potential of the Tobin tax to raise funding for social and environmental development and from my perspective is therefore undesirable.

Willmott et al. (2001) “believe that the tax revenue should be spent on development,” and that “it should not be left to individual states to allocate it, as decision-making will inevitably reflect self-interest.” They argue that “a new, untainted separate organ … within the UN system should be established” to perform distribution of the funds. A commission of independent advisors that, among other things, would “receive proposals from development bodies such as WHO and UNDP, as well as poor country governments and established NGOs” and would then “assess the suitability of those proposals and decide, in accordance with agreed policies and guidelines set out in the international agreement,” what to fund. The commission would “consist of independent members, not acting for any particular member state … elected by the member states” and obliged “to publish reasoned reports regarding spending decisions, in order to enhance the accountability and transparency of its activities.” However, with regard to international funding by a supranational body of some sort, Spahn (1996) argues that “the revenue-raising potential of the Tobin tax is so large that this alternative is unlikely to be accepted by all countries” and “assignment of tax revenues to an international organization would confer considerable power on that organization and is likely to arouse national resentments.” Moreover, Stecher (1999) points out that it will be difficult “to persuade the G7, and above all the US, to accept the loss of influence that would occur once these organisations [UN, IMF, or World Bank] gained a more independent income.”

I therefore agree with Wahl and Waldow (2001), who believe that “if the revenue was – at least partially – used for national purposes, it would be easier to gather more support for the tax on the part of national governments” while international uses “would help to get the support from developing countries” (p. 11). Thus, “a mixture of national and international expenditure might be optimal from a strategic point of view” (p. 11). Along these lines, Stecher (1999) cites a proposal by Kaul and Langmore that “low and lower-middle income developing countries would retain 100% of the proceeds, higher-middle-income countries could retain 90% and high income countries 80%.” Stecher also cites another suggestion that “50% of the revenue remains with the collecting country and the rest is distributed to multilateral organisations,” perhaps “in equal shares to the UN, IMF and World Bank.” Alternatively, Patomäki (2001) proposes that “the OECD countries should get 30% of the revenues they collect and others 60%. He believes that “this is substantial enough to compensate for administrative costs and create incentives to join in (also for the poorer states), and it also addresses the conventional notion of justice” but “it does not violate the idea that the Tobin tax regime is a global and collective endeavour.” In my opinion, some mixture between national and international expenditures is appropriate with the international funds distributed by an international organization developed along the lines suggested above by Willmott et al. (2001). Preferably, the system should be structured in such a way as to maximize international expenditures and benefits to poor countries while still gaining the support of the richer countries. Beyond this basic framework, I must agree with Willmott et al. (2001) that “it would be wrong to be overly prescriptive about what the proceeds from such a tax should be spent on” since “times change and so do priorities.”

Effect on Arbitrage

Stotsky (1996) argues that a Tobin tax “could impose a cost on financial markets … by potentially reducing stabilizing arbitrage. Similarly, Spahn (1996) notes that “the Tobin tax cannot distinguish, on an institutional basis, between normal trading that assures the efficiency and stability of financial markets and destabilizing noise trading, which should be the only target of the tax.” Spahn argues that “even leaving aside exemptions for market interventions by central banks and for transactions between governments and international organizations, there are strong economic and political arguments for exempting certain types of trades from the tax-for example, those made by market makers and those that increase market liquidity”and furthermore, “a case can be made to exempt all financial intermediaries from the tax on the grounds that their trading is usually stabilizing (through liquidity trading) rather than speculative. However, “exempting such institutions from the tax would simply encourage tax-free transactions by and through intermediaries” (Spahn, 1996).

Worse, Davidson (1997) suggests that the Tobin tax is actually “more likely to be a constraint on arbitrage flows rather than on speculative flows” because “during a speculative run on a currency, one expects significantly large changes in the exchange rate over a very short period of time” in which case a small Tobin tax would be relatively ineffective at reducing capital flows, but “when dealing with small differentials in exchange rates, however, one is likely to be discussing the question of arbitrage rather than speculation” (p. 678).

Zee (2000) admits that “it would be administratively difficult, if not impossible, to identify capital flows that are externality-generating from other financial flows that are not” since “the tax would have to be imposed on all cross-border financial flows, and would thus inflict a burden on transactions that are unrelated to the problem at hand.” However, he indicates that the “quantitative significance of this distortion relative to the cost of allowing destabilizing capital flows to remain unchecked” is unclear. The cost of this distortion is likely to be fairly small if Wahl and Waldo (2001) are correct. They argue that “the fact that a CTT would also prevent arbitrage if its profitability is below the tax rate need not be a disadvantage at all.” Rather, “arbitrage leads only to short term equalisation of market conditions and is a main contribution to volatility” and even without arbitrage in the short run, there will be a currency price equilibrium across markets” (p. 7-8).

Effect on Trade

As noted above, the Tobin tax “would be too small, relative to ordinary commercial and transportation costs, to have much effect on commodity trade” (Eichengreen et al., 1995, p. 165). Indeed, Palley (2000) notes that “trade which could not bear the addition of a 1/10 percent tax contained close to negligible social value, and any loss to society would also be correspondingly negligible.”

However, Davidson (1997) points out that “under the current flexible exchange rate system, there may be four or more normal hedging financial transactions involved in any single arms-length international trade transaction” and thus “a 0.5% Tobin tax could be equivalent to instituting an additional 2% universal tariff on all goods and services traded in the global economy” (p. 678-679). He concludes that “as long as some hedging transactions are required on arms-length real trade flows, the impact of the Tobin tax is likely to be at least as large and probably larger on international trade than on international portfolio flows” (p. 679).

Even taking this into account, the claim that a Tobin tax will have a noticeably negative impact on trade is uncertain at best. Palley (2000) argues persuasively that a Tobin tax “stands to reduce currency market uncertainty, thereby making it easier for firms to trade.” He explains that because “firms would pay less to hedge against foreign currency risk exposures incurred in the course of financing international trade” the cost of trade would be lowered, thereby increasing trade. He further notes that “exchange rate volatility has likely been an important factor explaining the growth of multi-national production … because it has given firms a reason to build up a portfolio of production facilities across countries to protect themselves against exchange rate fluctuations.” Therefore, “the reduction of currency risk that goes with reduced exchange rate volatility could induce firms to substitute away from multi-national production toward increased use of trade.”

Effect on Volatility

Welteke (2001) claims that “reduced trading on the currency markets means decreasing liquidity and, consequently, potentially greater volatility.” In response, Palley (2000) draws a distinction between short and medium term volatility. He admits that “[w]ith regard to the issue of short-term volatility, there is some ambiguity as to what the impact of a Tobin tax would be.” “On the one hand,” he explains, “the Tobin tax would raise the cost of transacting,” and this should “discourage random movements of the herd driven by factors unrelated to changes in economic fundamentals” and “might reduce the market presence of noise traders by lowering their expected profitability from trading” (Palley, 2001). On the other hand, since everyone agrees that a Tobin tax “would reduce the “volume†of transactions,” some have pointed out that “thin markets (i.e. markets with low transaction volumes) are often associated with large price volatility … because opinion tends to move one way in such markets, and diversity of opinion is needed to have both buyers and sellers.” In response Palley (2000) acknowledges that “if the Tobin tax were set at too high a level, it could so reduce the volume of transacting that currency markets became thin and volatility increased.” However,” he argues, “such an outcome seems implausible given the proposed small magnitude of the tax and given the enormous size of the existing market.” Moreover, as Palley points out, “what matters for the thinness of markets is the total cost of transacting … [t]hough the Tobin tax would raise marginally the cost of transacting, this cost would still be lower than it used to be owing to innovations in electronic transactions technologies, and the market was not thin in the past when transactions costs were higher.” He therefore concludes, “increased short-term volatility owing to reduced transactions volume (i.e. increased market thinness) is an unlikely outcome.”

In terms of medium term volatility there is no ambiguity, according to Palley (2000). He notes that “[e]xchange rates have tended to be marked by fairly prolonged swings that take them away from sensible values.” Noting that “[s]uch swings are extremely damaging to economies in that they distort the pattern of international production and trade,” Palley provides one explanation for these swings: “exchange rate adjustments tend to under- and over-shoot,” particularly because “investors may follow a ‘momentum’ model of buying and selling currencies, so that once a movement gets going it tends to generate an extrapolative dynamic of its own.” At some point, “the price gets driven so far away from that warranted by economic fundamentals, that the swing reverses” (Palley, 2000). Palley suggests that “the Tobin tax can help by potentially reducing the frequency and extent of such swings.”

Evasion – Evasion through Offshore Trading

Stotsky (1996) argues that “the mobility of financial transactions would make the tax easy to avoid unless the tax were internationally agreed upon and administered by each government” since, “[i]f transactions taxes applied to transactions only in domestic markets, investors could easily substitute foreign trading as a means to avoid the tax.” She then notes the political difficulty in getting all countries to agree to the specifics of an international tax pointing out that “it has proven difficult to get countries to agree upon uniform taxation in other areas of taxation, even by relatively homogeneous groups of countries, such as the European Union.” Although some supporters of the Tobin tax have argued that a non-universal Tobin tax with the establishment of “a punitive tax on trading with the outsiders and a relatively high tax on domestic-currency lending to actors not resident in the Tobin Tax Zone (TTZ)” could work (Patomäki, 2001), most advocates acknowledge that a Tobin tax “would have to apply to all jurisdictions” because, “were it imposed unilaterally by one country, that country’s forex market would simply move offshore” (Eichengreen et al., 1995, p. 165). Additionally, most advocates, myself included, are fully cognizant of the incredible political difficulty involved in garnering international support for the Tobin tax. However, this paper intends to focus mainly on the abstract desirability of the tax, and I will therefore leave the political strategizing involved for another author. [2]

Evasion through Derivatives and Other Financial Innovations

Stotsky (1996), arguing against a Tobin tax, notes that that “since investors can construct equivalent positions with derivatives as they would with cash instruments, transactions in derivatives should be taxed” but “it is difficult, however, to achieve equivalent taxation of cash and derivative instruments.” Spahn (1996) acknowledges that “substitutability of financial instruments thus poses a severe problem for the scheme” and that “the problem cannot be resolved simply by extending the tax to transactions in derivatives because the size of such transactions cannot be related to the underlying long transactions in a straightforward manner.” He notes further that “a Tobin tax on the transactions themselves would grossly understate the volume of funds that can be channeled through foreign exchange markets; however, taxing the notional value of a derivatives contract would probably severely damage the derivatives markets and might even destroy them completely.” And, “given the important role played by the forward and futures markets in hedging risks related to exchange rate fluctuations,” Spahn believes “the eventual disappearance of these markets would threaten the stability of foreign exchange markets.” Finally, Spahn maintains that taxing “the notional amounts of derivatives contracts, but at lower rates … would be justified by the lower costs of derivatives” but “is undesirable because it would create a selective tax system that would be arbitrary, formidably complex to administer, and biased.”

In the end, Spahn (1996) suggests a tax “on derivative trades at half the standard rate” which “would allow the derivatives markets to continue functioning at low cost while preventing the use of derivatives to evade taxes.” Stotsky maintains that such solutions are “not appropriate” because “[g]iven the complexity of the strategies underlying the use of derivatives, it would be impossible to establish one rate for derivatives and one for the underlying instruments that would yield exact tax equivalences,” and “markets would quickly figure this out.” Moreover, Garber and Taylor (1995) remark that to adjust for continuing financial innovation, “the tax would have to be extended out of straight foreign exchange to transactions in ever-widening ring of securities and derivatives markets” (p. 180).

I find Palley’s (2000) responses ultimately convincing. First he admits that it is “undoubtedly true” that “financial markets will innovate to avoid” the tax. However, he maintains that “such substitution is costly both in resource use, and because alternative instruments do not provide exactly the same services” and “[t]hese costs act as a check on the incentive to substitute.” Even Garber and Taylor (1995), who oppose the Tobin tax, state that the substitutes “deal in ever less liquid markets that are not perfect substitutes for foreign exchange” and eventually, “a point will be reached, therefore, when extending the tax to transactions in additional securities markets will cause explicit foreign exchange transaction to reemerge, although on a reduced scale” (p. 180). On a more basic level, Palley (2000) remarks that “effective taxation places costs on profit maximizing firms” and “firms therefore have an incentive to search out ways of avoiding taxes.” “Over time they inevitably succeed in doing so” he points out, and “if the incentive to avoid is not there, it probably means the regulation is of little consequence.” Moreover, as Wahl and Waldo point out, wealth and capital income taxes are “easily evadable … yet, nobody has demanded the abolishment of these taxes” (p. 11). For Palley, the likelihood that investors will find ways to avoid the tax does not invalidate the case for a Tobin tax. Rather it “affirms the fact that regulation is an on-going process – a dynamic game played between regulators and regulated – that needs to be continually updated.” In any case, this “is never an excuse for capitulating and surrendering the public interest to the dictates of the market.”

Finally, although it is beyond the scope of this paper to discuss the idea in more detail, in response to the ability of investors to skirt a Tobin tax on foreign exchange transactions, through the use of various financial instruments, Palley urges the adoption of “a generalized securities transactions tax.” He cites four advantages to such an approach: “First, it is likely to generate significantly greater revenues. Second, it maintains a level playing field across financial markets so that no individual financial instrument is arbitrarily put at a competitive disadvantage versus another. Third, it is likely to enhance domestic financial market stability by discouraging domestic asset speculation. Fourth, to the extent that advanced economies already put too many real resources into financial dealings, it would cut back on this resource use, freeing these resources for other productive uses.”

I present this idea here only to show that if evasion through financial instruments becomes a major problem for a Tobin tax, there are alternatives beyond just giving up and accepting the status quo of unregulated foreign exchange transactions.

Tax collection

The issue of tax collection is obviously intimately related to the previous discussion about evasion. I revisit the issue only to mention an innovative and oft-cited suggestion by Schmidt (1999) that seems to makes sense to me. He explains that: “Settlement risk” exists when one party to a transaction makes an irrevocable payment of a currency or delivery of a security denominated in that currency before its counterpart makes the opposing payment to complete the exchange of assets and settle the transaction. … Settlement risk is eliminated when the two payments are matched, traced to the original foreign exchange trade and made simultaneously. … As a result of rising foreign exchange trading volume, new technology and efforts to reduce settlement risk, the infrastructure in place to make interbank foreign exchange payments is increasingly formal, centralised and regulated.

Schmidt then goes through a detailed description of the inner workings of the international settlement processes to conclude that “foreign exchange settlement technology and institutions now in place make it possible to process gross payments, match payments and trace them to the original foreign exchange transaction and regulate offshore netting systems.” He maintains that “these features are necessary and sufficient for Tobinâ€^TMs tax.”

Administrative Cost

Stotsky (1996) suggests that “the introduction of even the simpler Tobin tax in major financial markets would entail significant administrative costs in developing methods for its collection, monitoring, and enforcement.” It seems to me however, that this is a spurious argument. The administrative costs involved in enforcement, monitoring etc. will be at most a minor portion of the huge revenues raised likely to be generated from the tax.

IV. Conclusion

The Tobin tax seems likely to increase monetary autonomy to some degree as well as reduce the likelihood and probably the severity of financial crises. In addition, it will generate significant sums of money that if divided and used democratically with transparency and accountability could go a long way to towards providing for basic needs and environmental improvements. At the same time, it is not a panacea for all the problems of the international economy and a Tobin tax will likely be most effective in combination with other measures to control capital.

I admit that valid concerns have been raised with regard to evasion and collection of the tax. Although I find the responses provided above by advocates of the Tobin tax to be convincing, on balance, it seems difficult to know with any measure of certainty how investors will react. That said, in the final analysis, I must agree with Eichengreen et al. (1995) who argue: “the task of economics is to weigh alternatives. It is not enough to point to the administrative difficulties of intervening in the operation of markets or to risks of evasions. These costs must be weighed against those of alternative courses of action, including the cost of doing nothing. … For the world as a whole, the costs of the status quo are high if macroeconomic policy is hamstrung and if it is diverted from more fundamental targets by exchange rate swings. (p. 170)”

- by Julian Dautremont-Smith

References

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Burkett, Paul and Martin Hart-Landsberg. 2000. Development, Crisis, and Class Struggle: Learning from Japan and East Asia. New York: St. Martin’s Press.

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Footnotes

[1] The underlying causes of the Asian crises may perhaps be structural in nature (Burkett and Hart-Landsberg, 2000) but it seems undeniable that the catalyst the directly set off the crises was a sudden outflow of funds from Thailand, followed by outflows from Malaysia and Indonesia.

[2] Readers interested in questions about political implementation of a Tobin tax and the possibilities for non-universal foreign exchange taxes are encouraged to refer to Willmott et al. (2001), Patomäki (2001), and Palley (2000).