The potential and feasibility of the Tobin financial transactions tax:

An overview

Nikolaos Karagiannis (*I

Abstract

The purpose of this paper is to evaluate the proposals for a tax on foreign exchange

dealings (i.e. Tobin tax). It is assumed that such a tax could be levied on a coordinated

international basis in a workable manner, and this enables us to discuss the merits and

demerits of the tax. The last main section discusses the feasibility of the proposed Tobin

tax.

'*' Nikolaos Karagiannis Ph.D., Sir Arthur Lewis Institute of Social and Economic Studies and Department of Economics, The University of the West Indies, Mona, Kingston 7, JAMAICA.

1. Introduction

There has been considerable interest in the idea of a tax levied on financial transactions,

particularly on those involving foreign exchange dealings. The root of the argument is

that many financial market transactions are purely speculative and as such they merely

reallocate the ownership of existing financial assets without any beneficial impact on the

productive economy. Indeed, volatility of prices thereby generated may have adverse

effects on the real economy. In terms of currency markets, it led Tobin (1978) to propose

the taxation of foreign exchange transactions, and a fiscal intervention now normally

labelled as the "Tobin tax".

The origins of the Tobin tax idea can be traced to Keynes' assertion in the Treatise on

Money that it may be necessary to tax foreign lending to restrain speculative capital

movements. In 1936, Keynes argued that "The introduction of a substantial government

transfer tax on all transactions might prove the most serviceable reform available, with a

view to mitigating the predominance of speculation over enterprise in the United States"

(Keynes, 1936; p. 160). In 1972, ~ o b i n ' (1974, see also 1978, and Eichengreen, Tobin

and Wyplosz, 1995) explicitly proposed a tax on foreign exchange transactions as a way

of limiting speculation, enhancing the efficacy of macroeconomic policy in the process

and raising tax revenue as a by-product. After the Stock Market crashes of 1987,

Summers and Summers (1 989) (see also Stiglitz, 1989; 1990) updated the argument and

proposed new taxes on securities transactions. Also, concern has emerged in view of the

severe speculative attacks on the European Exchange Rate Mechanism (ERM). For this

reason, Kelly (1993, 1994) and Harcourt (1995) have advanced variants of a tax on

foreign exchange dealings (see also Neuburger and Sawyer, 1990).

In addition, official interest in a financial transactions tax has been expressed by United

Nations Development Programme (UNDP,1994) and UNCTAD (1995), who have seen

its possibilities for raising large amounts of revenue which could be used to finance

development. It is also worth noting that in the wake of the 1994 Mexican peso crisis,

even the IMF endorsed, albeit cautiously, limited reliance on transactions taxes and

restrictions on selected international financial dealings (Folkerts-Landau and Ito, 1995).

' In his Janeway lecture at Princeton, in Honour of Joseph Schumpeter.

2

2. Rationales for a transactions tax

Three rather different (but not mutually exclusive) sets of reasoning have been advanced

in support of a transactions tax. The first is that there is a sense in which the volume of

foreign exchange transactions are excessive, being many times greater than the volume

required to finance trade. This volume of transactions absorbs resources to effect the

transactions and is seen to have an adverse effect on the world economy. In a world of

floating exchange rates, this large volume of transactions is often viewed as generating

volatility in exchange rates, as well as intensive short-termism and chronic bouts of

speculative financial excess, with consequent detrimental effects on real economies.

The second rationale for a financial transactions tax is simply its tax raising potential.

Tobin (1978) suggested a tax rate of 0.5% on such transactions, but "even a tax of 0.05%

during 1995-2000 could raise $150 billion a year. Such a tax would be largely invisible

and totally non-discriminatory" (United Nations Development Programme, 1994; p. 9).

These tax receipts could be used for worldwide investments. Besides, this may be linked

to the view that the financial sector is relatively undertaxed in the sense that financial

transactions do not usually bear general sales or value added taxes nor are they usually

subject to specific taxes in the way in which, for example, tobacco and alcohol are. Table

1 reports for a range of countries the proportion of tax revenue arising from taxes on

financial and capital transactions, and these include taxes on the buying and selling of

equity. It can be seen from the table that on average such taxes account for 1.3 1% of tax

revenue. It is worth pointing out here that most industrialised countries do, in fact, have

transaction taxes (Campbell and Froot, 1994; summarised in Frankel, 1996).

The third rationale concerns the possibility of enhancing the autonomy of national

economic policy, and reducing the constraints on such policy imposed by the financial

markets. This runs counter to the widely held view that since financial markets "know

best" (and since exchange rates and stock markets prices reflectfundamentals) they exert

a healthy discipline on central banks and governments. Adverse capital movements is the

usual example cited to support this view.

Table 1 Proportion of total tax revenue accounted for by taxes

on financial and capital transactions, 1994 (%)

Australia 4.34 Austria 0.70 Belgium 1.86 Canada 0.00 Denmark 0.88 Finland 0.88 France 1.13 Germany 0.57 Greece 2.22 Ireland 1.57 Italy 2.29 Japan 2.13 Netherlands 1.17 New Zealand 0.5 1 Norway 0.33 Portugal 0.1 1 Spain 2.54 Sweden 0.68 Switzerland 2.12 Turkey 1 .SO U.K. 0.80 U.S.A 0.14 Average 1.31

Source: Calculated from OECD (1 995).

3. Reasons for interest in Tobin tax

The reasons for the increased interest recently in the Tobin tax proposals are threefold.

The first is the growing volume of foreign exchange trading. The volume of foreign

exchange transactions worldwide reached $1,300 billions a day in 1995 (with the cor-

responding figure in the early 1970s being $18 bitlion), equivalent to $3 12 trillion a year

of 340 business days (Tobin, 1996; p. xvi). By comparison, the annual global turnover in

equity markets in 1995 was $21 trillion, the annual global trade in goods and services was

$5 trillion, and total reserves of central banks around $1.5 trillion at the end of 1995.

Based on the current composition of foreign exchange dealings, the U.K. would collect

near to 30% of the total tax revenue, U.S.A almost 16%, Japan 10% and Singapore 7% in

1995 (see Table 2).

Table 2 Countries with the largest volume of trading in foreign currency:

Daily average foreign exchange turnover, 1992 and 1995 (US$ billion) COUNTRY 1992 % share 1995 % share U.K. 290.5 27 464.5 30 U.S.A Japan Singapore Switzerland Hong Kong Germany France Australia All others Total of above

Source: BIS estimates, reported in Felix (1996).

The second reason is that a transactions tax is now seen as important not merely by

policy-makers and others concerned with foreign exchange market volatility, but by those

who attach significance to public financing of world development. The third reason is an

increasing realisation that foreign exchange markets do not operate in as an efficient

manner as portrayed in, for example, the rational expectations literature. It is recognized

that foreign exchange markets suffer from persistent misalignments and unstable

exchange rate regimes, asymmetric information and herd behaviour, and moral hazard

when participants are too big or powerful to fail.2

Two broader issues arise here. The first is how are financial markets to be modelled,

particularly with regard to speculation? Second, what is the nature of the relationship

between the real sector and the financial sector?

2 Asymmetric information and herd behaviour imply that incompletely informed investors suffer bouts of optimism and pessimism. In fact, foreign exchange market speculators watch other speculators rather than "market fundamentals" (Kindleberger, 1978; Eichengreen and Lindert, 1989; Eichengreen, 199 1 ; Frankel, 1996; Felix and Sau. 1996; discuss these issues).

It is clear that there are two distinct traditions in the analysis of competitive markets. The

first, which can be associated initially with Friedman (1953), suggests that speculation

would be stabilising in a competitive foreign exchange market. Speculation is the act of

buying or selling seeking to benefit from price movements rather than to finance inter-

national trade, or to acquire interest bearing assets. The mechanism is clear: when price is

above equilibrium, speculators believe that the price will fall, and consequently sell now

to gain from the currently high price. Their actions help the price to fall and hence to

move more quickly to equilibrium. The assumption of rational expectations held by

market participants will merely serve to reinforce the conclusions.

The second tradition begins with Keynes (1936) who emphasized the role of expectations

and perceptions of the views of others ("we devote our intelligences to anticipating what

average opinion expects the average opinion to be", p. 156), the instability which arose

from speculation and the suggestion that long-term commitment should be encouraged. In

this second approach, market operators are more concerned with the rate of change of

price than with the price level. This has variously been described as, for example, "noise"

trading and trading motivated by price signals. The key issue is to whether market prices

are based on economic fundamentals or bubbles, fads and herd behaviour.

4. Incidence and distortionary effects of transactions tax

The final incidence of the transactions tax is significant for at least three reasons:

(i) the extent to which the tax falls upon those involved in international trade or in

long-term foreign investment will determine the degree to which the transactions

tax reduces inter-national trade and investment;

(ii) the incidence of the tax will influence the impact on the level of aggregate

demand; and,

(iii) the distributional effects of the tax will clearly depend on the final incidence of

that tax.

However: the application of an international tax would raise questions of the allocation of

the proceeds of the tax. A number of proposals have been put forward on the way to

distribute the tax proceeds. To the extent that it is the IMF or World Bank who are the

intermediate recipients, a further proposal may be to enhance the lending capabilities of

these institutions especially to the third world countries which could embrace growth and

development, and anti-pollution projects. Kaul and Langmore (1996) focus on three

proposals: the "Agenda 2 1 " action programme emanating from the 1992 UN Conference

on Environment and Development which would cost $125 billion per annum in terms of

external concessional financing alone; a poverty eradication programme as formulated at

the World Summit for Social Development in 1995 at an additional external cost of $40

billion per annurn; infrastructure and other needs which according to World Bank

estimates would involve external concessional funding of around $20 billion per annum

(total $185 billion per annurn). Part of the international agreement could clearly be that a

proportion of the tax collected is paid over to an international body andfor used for agreed

development and environmental purposes (in one way this would be comparable to the

collection of value added tax in EU member countries with the equivalent of 1% of turn-

over being handed on to the European Commission).

The workings of the tax could be reinforced by making the administration of a trans-

actions tax to be a condition of membership of the IMF and the BIS though that may not

be sufficient to prevent the growth of off-shore dealings since a small country would have

so little to gain from membership of the IMF as compared with the potential revenue for

the location of off-shore financial markets (though if the off-shore locations are

competing on the basis of low or no tax, there is the question of how much revenue

would be generated). It can also be asked whether the tax could be levied on the

participants based on their location rather than on the basis of the location of the trans-

action.

One common argument raised against the Tobin tax relates to its pcssible distortionary

effects. The argument is straight-forward with a tax which leads in a competitive market

to an equilibrium being established which involves lower quantity and fewer resources

being allocated to that particular market. As Eichengreen and Wyplosz (1996, p. 15)

remark "most economists are instinctively sceptical about taxing international financial

transactions as a way to enhance the operation of the international monetary system".

For the proposed transactions tax there are three points to be made in connection with this

argument. First, the financial sector may be relatively lightly taxed, and the products of

the financial sector are generally not subject to either general sales or value added taxes

nor to specific excise taxes and the like. This would mean that the imposition of a

transactions tax may, in effect, be removing some distortions rather than imposing them.

Second, the distortionary nature of a tax arises from some potentially beneficial trades not

taking place that would have otherwise happened. This leads us back to the question,

namely, are there gains from the current volume of exchange transactions which would

not arise with a substantially smaller volume? Third, the analysis of distortions is an

equilibrium one. But there is a sense in which much of the trading in currency markets is

disequilibrium trading in terms of seeking to take advantage of price changes.

Thus, the conventional analysis of distortions does not apply to this situation, and if it is

argued that the amount of "noise trading" is excessive, then a tax is beneficial rather than

distortionary.

5. Possible obstacles

There can be little doubt that the introduction of a transactions tax would be a major

economic and political development but at the same time it would have to be introduced

on a "big bang" basis. Otherwise foreign exchange dealings would quickly move to those

countries which were not applying the tax.

However, the institution of a transaction tax would be vigorously opposed by many as an

interference in the market mechanism which would make it more inefficient and dampen

capital investment. It could be argued that volatility is not a result of speculation but

rather of balance-of-payments problems and uncoordinated national monetary policies,

and that so-called speculators actually include companies changing currencies to protect

themselves against losses from a depreciation of their currency holdings. It could also be

asserted that the market is now too large for any single private or public party to sway,

and that the activities of speculators actually contribute to the liquidity of the market. In

view of the above, it is probable that the proposed tax, in political and practical terms,

would be a "non-starter" (klendez, 1996; p. 500).

Furthermore, there are clear political obstacles to the introduction of a transactions tax.

Two main obstacles stand out, namely:

(i) the international co-ordination which would be required; and,

(ii) the political power of the financial sector.

There is widespread agreement that the Tobin tax would have to be implemented on a co-

ordinated international basis, through an international agreement, giving it its global

characteristic. But revenue collection would be a national responsibility. The obvious

difficulty which arises here is obtaining international agreement over the introduction and

the rate of the tax, when the revenue from the tax would be so unequally distributed

across countries. Furthermore, it would be expected that the economic and political

influence of the financial markets would also be reduced.

6. Concluding remarks

The Tobin transactions tax is a feasible tax for raising substantial sums of taxation. It

would substantially reduce the volume of foreign currency transactions, with significant

resource savings and the hope that it would diminish the volatility of exchange markets.

However, its introduction would face formidable political problems and obstacles and its

implementation would need to be carefully arranged. In this sense, we should conclude by

suggesting that the Tobin tax by itself cannot perform miracles. It would seem more

appropriate to use the Tobin tax as one of several policy instruments that could be

deployed to discourage speculation or unsustainable short-term capital flows.

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