The “Tobin Tax” Proposal

Ben Patterson, European ParliamentBen Patterson, European Parliament

Research Research

(WIP 56738)(WIP 56738)

Professor James Tobin, 1918 –

The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1981

"for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices."

“The tax that will not die”

19721972, the end of Bretton Woods. Tobin first , the end of Bretton Woods. Tobin first proposes throwingproposes throwing “some sand in the well-“some sand in the well-greased wheels of international financegreased wheels of international finance””..

19781978: Tobin further develops the proposal.: Tobin further develops the proposal.

1992/31992/3: EMS crisis. : EMS crisis.

19951995: Mexican crisis.: Mexican crisis.

19971997: Asian crisis. : Asian crisis.

1998/991998/99: Russia; Brazil; etc.: Russia; Brazil; etc.

Some political developments19941994: Mitterand proposes study of Tax at Copenhagen : Mitterand proposes study of Tax at Copenhagen

world social summit.world social summit.

1995: Jospin puts Tax in election platform.: Jospin puts Tax in election platform.

1998:1998: Founding of the “Association for the Taxation of Founding of the “Association for the Taxation of Financial Transactions for the Aid of Citizens” Financial Transactions for the Aid of Citizens” (ATTAC)(ATTAC)

19991999: Canadian Parliament votes for Tax.: Canadian Parliament votes for Tax.

20002000: Call for Commission study of Tax : Call for Commission study of Tax defeated defeated 220-226 in European Parliament.220-226 in European Parliament.

20012001: EU Council asks for new study.: EU Council asks for new study.

Some academic studies1993: 1993: Eichengreen and WyploszEichengreen and Wyplosz: “The Unstable EMS” : “The Unstable EMS” Brookings Papers.Brookings Papers.

1995: 1995: Kenen:Kenen: “Capital Controls, the EMS and EMU” “Capital Controls, the EMS and EMU” Economic Journal.Economic Journal.

Schmidt:Schmidt: “Taxing International Short Term Capital Flows” “Taxing International Short Term Capital Flows” Canadian Dept. of Finance.Canadian Dept. of Finance.

Eichengreen, Tobin and WyploszEichengreen, Tobin and Wyplosz: “Two cases for sand in the : “Two cases for sand in the wheels of international finance” wheels of international finance” Economic Journal.Economic Journal.

Felix:Felix: “The Tobin Tax Proposal” “The Tobin Tax Proposal” Futures.Futures.

1996: 1996: SpahnSpahn: “The Tobin Tax and Exchange Rate Stability” : “The Tobin Tax and Exchange Rate Stability” Finance and Finance and Development.Development.

1999:1999: Kasa:Kasa: “Time for a Tobin Tax?” “Time for a Tobin Tax?” Federal Reserve Bank of San Federal Reserve Bank of San FranciscoFrancisco

2000: 2000: “Promoting the Stability of International Capital Movements” “Promoting the Stability of International Capital Movements” (2000) Finnish Ministry of Finance.(2000) Finnish Ministry of Finance.

Objectives of a Tobin Tax

1.1. To favour “investment” rather than To favour “investment” rather than “speculation”.“speculation”.

2.2. To fight currency and other crises. To fight currency and other crises.

3.3. To reduce exchange-rate volatility. To reduce exchange-rate volatility.

4.4. To give governments greater freedom in To give governments greater freedom in pursuit of monetary and economic policy .pursuit of monetary and economic policy .

5.5. To raise revenue. To raise revenue.

How the Tax would work

An An ad valorem ad valorem charge on the grosscharge on the gross sum of sum of any foreign exchange transaction.any foreign exchange transaction.

A “speculative” operation (e.g. € to $ to €) A “speculative” operation (e.g. € to $ to €) would therefore incur the tax twice.would therefore incur the tax twice.

Tobin’s original proposal was a rate Tobin’s original proposal was a rate between 0.1% and 0.5%.between 0.1% and 0.5%.

Other suggestions between 0.01% and 1%.Other suggestions between 0.01% and 1%.

1. Favouring “investment” over “speculation”

95%95% of currency transactions have no of currency transactions have no connection with trade in goods and services.connection with trade in goods and services.

Over Over 40%40% are concluded within 3 days, are concluded within 3 days, 80%80% within a week. within a week.

Over Over 60%60% take place between foreign take place between foreign exchange dealers.exchange dealers.

Simple annualised rates(assuming fixed exchange rates)

NominalRate (%)

Effective rate (annual %)

1 day 1 week 1 month 3 months 1 year 10 years

0.01 7.3 1.04 0.24 0.08 0.02 0.002

0.1 73 10.4 2.4 0.8 0.2 0.02

0.2 148 20.8 4.8 1.6 0.4 0.04

0.5 365 52.0 12.0 4.0 1.0 0.1

1 730 104.0 24.0 8.0 2.0 0.2

Compound calculations Tobin’s calculation: transaction carried out Tobin’s calculation: transaction carried out

each day/week/month/year x 2.each day/week/month/year x 2. Compound calculations (e.g.Eichengeen Compound calculations (e.g.Eichengeen

and Wyplosz, 1993) produce annualised and Wyplosz, 1993) produce annualised rates, based a nominal rate of 1%, of:rates, based a nominal rate of 1%, of:

Monthly (12): 27%.Monthly (12): 27%. Weekly (30): 181%. Weekly (30): 181%.

Daily (220): 7,980%.Daily (220): 7,980%.

2. Crises and the role of speculation

Currency crises (e.g. ERM 1992/3).Currency crises (e.g. ERM 1992/3). Banking/financial crises (e.g. Asia 1997).Banking/financial crises (e.g. Asia 1997). Debt-servicing crises (e.g. Argentina 2002).Debt-servicing crises (e.g. Argentina 2002).

BUTBUT To what extent can these be attributed to To what extent can these be attributed to

“speculation”?“speculation”? Would a “Tobin Tax” help?Would a “Tobin Tax” help?

Currency crises: the EMS 1992/3

““Black Wednesday” 1992.Black Wednesday” 1992. Market Market perception of “fundamental misalignment” perception of “fundamental misalignment” of Pound and Lira.of Pound and Lira.

BUTBUT Mid-1993.Mid-1993. French inflation (2%) half that of French inflation (2%) half that of

Germany.Yet FF forced below ERM floor.Germany.Yet FF forced below ERM floor. By end 1993 FF back to original parity.By end 1993 FF back to original parity.

Spahn: a “multi-tier” tax.

High rates needed to prevent speculative High rates needed to prevent speculative attacks; but these would disrupt markets.attacks; but these would disrupt markets.

Spahn solution (1996)Spahn solution (1996)

1. A “minimal-rate” 1. A “minimal-rate” transactions taxtransactions tax (applied at half-rate to derivatives).(applied at half-rate to derivatives).

2. An “2. An “exchange surchargeexchange surcharge”, activated ”, activated when trading price passed a threshold.when trading price passed a threshold.

3. Exchange-rate Volatility

““Whether a Tobin Tax is desirable depends Whether a Tobin Tax is desirable depends on your beliefs about the efficiency of the on your beliefs about the efficiency of the foreign exchange marketsforeign exchange markets” ”

(Kenneth Kasa 1999)(Kenneth Kasa 1999)

Exchange rates

Market rates and “equilibrium” rates.Market rates and “equilibrium” rates.

Market rates and “economic fundamentals” Market rates and “economic fundamentals” (e.g. €/$ rate).(e.g. €/$ rate).

““Exchange rates are relative prices of national currencies, Exchange rates are relative prices of national currencies, ... determined by the interplay of supply and demand in ... determined by the interplay of supply and demand in foreign exchange marketsforeign exchange markets.”.” (OECD, 1985). (OECD, 1985).

““The forward exchange rate contains virtually no The forward exchange rate contains virtually no information on future spot ratesinformation on future spot rates”.”. (Prof.Goodhart, 1988) (Prof.Goodhart, 1988)

Capital markets from 1980

Deregulation Deregulation

Technological advanceTechnological advance

Financial innovationFinancial innovation

1989-98 Currency trading + 10-15% a year.1989-98 Currency trading + 10-15% a year.

Now c. $2000 billion per day. Now c. $2000 billion per day.

Sources of instability

Bandwagons, bubbles, and overshoot.Bandwagons, bubbles, and overshoot.

Contagion. Contagion.

Self-fulfilling prophesies (e.g. devaluation).Self-fulfilling prophesies (e.g. devaluation).

Multiple equilibria.Multiple equilibria.

““Moral hazard”.Moral hazard”.

““Government failure”.Government failure”.

The 1997 Asian crisis (5 countries)Net private capital flows (source IMF)

1993 1994 1995 1996 1997 1998 1999

$ billionnetdirect

8 9 8 8 10 9 10

netportfolio

17 10 17 20 13 -6 6

bank &other

7 17 49 37 -44 -28 -41

Sources of stability Capital flows to finance current account Capital flows to finance current account

deficits (e.g. $).deficits (e.g. $).

Risk-sharing, hedging and arbitrage.Risk-sharing, hedging and arbitrage.

80% of daily flows are “hot-potato” trading.80% of daily flows are “hot-potato” trading.

So Tax could prevent the spreading of risk.So Tax could prevent the spreading of risk.

BUT BUT reduced volatility would mean less reduced volatility would mean less hedging needed (Tobin 1994).hedging needed (Tobin 1994).

Exchange-rate volatility (Source: P.De Grauwe, 1996)

Standard deviation (monthlychanges)

Mean average (monthlychanges)

DM/$ Yen/$ £/$ DM/$ Yen/$ £/$

1970s 3.5 3.2 2.8 2.5 2.0 2.1

1980s 3.6 3.5 3.6 2.9 2.8 2,8

1990s 3.3 2.9 3.5 3.4 2.3 2.5

4: Freedom in macro-economic policy

The Tax would give authorities greater The Tax would give authorities greater leeway to set leeway to set short-term interest ratesshort-term interest rates.. Under interest rate parity condition, rates Under interest rate parity condition, rates

could be lower, without triggering capital could be lower, without triggering capital outflow.outflow.

Less external constraint on policies to Less external constraint on policies to stimulate stimulate growth, employmentgrowth, employment, etc., etc.

Potential range for interest rate(“Tobin Tax” rate 0.25%)

Maturity Maximum % Minimum %1 day 550 01 week 36 01 month 12 03 months 9.3 0.96 months 6.1 3.91 year 5.5 4.5

Limitations

Assumes expectations of exchange rate Assumes expectations of exchange rate stability.stability.

A 1% tax would A 1% tax would notnot have this effect if have this effect if depreciation > 1% expected.depreciation > 1% expected.

Gives freedom only at short end of yield Gives freedom only at short end of yield curve (limited effect on real economy)curve (limited effect on real economy)

5. Revenues (estimate by David Felix, 1995)

Taxable amount Annual receipts1% rate ($109)

$1 trillion x 240 (trading days) =$240 tr.less 20% exemptions = $192 tr.

less 20% evasion = $144 tr.

less 50% reduction of tradingvolume= $72 trillion effective tax base $720 billion

Uncertainty of estimates

$54 billion p.a. on basis of 0.1% tax $54 billion p.a. on basis of 0.1% tax (Rodney Schmidt, 1995).(Rodney Schmidt, 1995).

The higher the rate, the lower the volume of The higher the rate, the lower the volume of trading.trading.

Centralisation of market would shrink Centralisation of market would shrink market to a FIFTH of present size (De market to a FIFTH of present size (De Grauwe).Grauwe).

Some practical problems

Which transactions?Which transactions?

How to prevent evasion?How to prevent evasion?

Who would get the money?Who would get the money?

Which transactions?

ExemptionsExemptions: official transactions; small : official transactions; small transactions; within “currency areas” transactions; within “currency areas” (Tobin).(Tobin).

CoverageCoverage: spot (only 40% of currency : spot (only 40% of currency transactions); currency transactions); currency andand interest rate interest rate swaps; T-bills; etc. swaps; T-bills; etc.

How to prevent evasion? Lesson of the US “interest equalisation Lesson of the US “interest equalisation

tax” of early 1960s.tax” of early 1960s.

““Tax havens” (BUT perhaps now less of Tax havens” (BUT perhaps now less of a problem).a problem).

International supervision and sanctions.International supervision and sanctions.

New financial products (“Alice and the New financial products (“Alice and the Red Queen” effect).Red Queen” effect).

Who would get the money?

Tobin’s original proposal: all revenues to Tobin’s original proposal: all revenues to IMF and World Bank.IMF and World Bank.

Later: Shared with national governments Later: Shared with national governments (but biased to poorer countries).(but biased to poorer countries).

UN budget (incl. agencies): $20 billion.UN budget (incl. agencies): $20 billion.Official aid of OECD countries: $50 Official aid of OECD countries: $50

billion.billion.

Alternatives

Direct capital controlsDirect capital controls (permits, exchange (permits, exchange regulations, inconvertibility, etc.).regulations, inconvertibility, etc.).

““Chilean solution”Chilean solution” 1991-98 (reserve 1991-98 (reserve requirements of limited duration on capital requirements of limited duration on capital imports).imports).

Conclusion: would a Tobin Tax work?

1.1. Investment, not “speculation”.Investment, not “speculation”.

2.2. Speculative attacks and crises.Speculative attacks and crises.

3.3. Exchange rate volatility.Exchange rate volatility.

4.4. Monetary policy autonomy.Monetary policy autonomy.

5.5. Revenues.Revenues.

1. “Investment” not “speculation”

Would increase costs of risk-taking, and of Would increase costs of risk-taking, and of “imprudent” policies (e.g. deficit finance).“imprudent” policies (e.g. deficit finance).

Would reduce short-term movements.Would reduce short-term movements.

BUTBUT Difficult/impossible to disentangle Difficult/impossible to disentangle

“speculation” from “investment”.“speculation” from “investment”. Could make ordinary trade in goods and Could make ordinary trade in goods and

services more expensive.services more expensive.

2. Prevent crises Could prevent currency crises where Could prevent currency crises where

fundamentals sound (e.g. FF 1993).fundamentals sound (e.g. FF 1993). Could discourage over-exposure by Could discourage over-exposure by

financial systems.financial systems.

BUTBUT Of no effect where parities misaligned.Of no effect where parities misaligned. Effects limited unless tax at unacceptably Effects limited unless tax at unacceptably

high level.high level.

3. Reducing exchange-rate volatility

Sharply reduced volume of trading likely.Sharply reduced volume of trading likely. Volatility might fallVolatility might fall, in so far as trading , in so far as trading

de-stabilises (short-term profit, bandwagon de-stabilises (short-term profit, bandwagon effects, etc.).effects, etc.).

BUTBUT Volatility might increaseVolatility might increase in so far as in so far as

trading stabilises (hedging, arbitrage, risk-trading stabilises (hedging, arbitrage, risk-spreading, etc.)spreading, etc.)

4. Monetary policy autonomy

Greater freedom in setting short-term Greater freedom in setting short-term interest rates.interest rates.

Greater freedom to pursue growth- and Greater freedom to pursue growth- and employment-orientated policies.employment-orientated policies.

BUTBUT Little effect on rates over 1 year maturity.Little effect on rates over 1 year maturity. Exchange-rate expectations must be stable.Exchange-rate expectations must be stable.

Revenues

$50 - $300 billion depending on:$50 - $300 billion depending on:elasticities and reduction in trading;elasticities and reduction in trading;degree of evasion and avoidance.degree of evasion and avoidance.

BUTBUT Enough to fund UN, and all official aid by Enough to fund UN, and all official aid by

OECD countries.…and perhaps much more.OECD countries.…and perhaps much more.