Tobin Tax

I agree with Ezra Klein’s commenters that this list of Five Lies My Economist Told Me from Foreign Policy is a fairly elementary view of of the problems with the current economic order. That said it does provide me an opportunity to talk about Big Lie #3: the free flow of international capital is a good thing. Keep in mind that I’m not an economist; I just get to play one on this blog.

Basically, there’s a lot of evidence that financial volatility is increasing. Foreign Policy mentions the Asian Financial Crisis, which is important, but just one data point. Many nations (~4 per year) have had financial crisis since the US currency float changed the rules of international capital. Moreover, as currency trading increases, central banks are less and less able to intervene to stabilize the markets, nations lose their ability to organize their economy, etc., etc., very bad things, etc..

A brilliant solution proposed by James Tobin is to tax currency exchange transactions at a very low rate (~0.05%), which is still greater than the profit margin of the short-term (a couple hours between buy and sell), speculative exchanges that are the primary cause of volatility. Tobin’s idea was itself a rehashing of Keynes’s proposal to tax US stock trading in the same way to similarly prevent the dominance of short-term investors.

The Tobin Tax is an important tool in liberating the world economy from the control of the Clintons (just kidding, sorry Chelsea), and big investment firms. Which is why it’s no surprise that back in 2000, Representative DeFazio and Senator Wellstone introduced Tobin Tax bills to their chambers. They were right then and they still are.

Below the fold I’m including my full argument for the Tobin Tax featuring almost all the latest research from befoe 2002,when I abandoned the paper (and economics). Missing is a discussion of Paul Spahn’s proposal for an exchange rate band, rather than a tax, as well as part of the solvency link. I’m sure no one will notice=). It feels very satisfying to preserve such a time intensive paper online, even if I’d be shocked if economic policy memos are engaging to anyone. Enjoy!

To: President Bush
From: Quixote
Date” 10 December 2001
Re: Using the Tobin Tax to Combat Exchange Rate Instability

The US needs to join the emerging coalition of social groups and progressive governments in advocating internationally for a universal .05% Tobin Tax as a partial measure to fight financial volatility and excessive capital mobility. This tax can be effective up to a point at correcting for ‘moral hazard,’ decreasing speculator pathology, and preventing multiple equilibria while creating space for countries to pursue a more autonomous monetary and fiscal policy.

Our decision in this matter must be guided by the overarching objectives of US trade policy. Specifically, we need to evaluate the Tobin Tax based on its ability to promote global living standards and democracy relative to the status quo.

Dangers of the Current Financial System
The international financial system is faced with two major problems that can have devastating impacts on the welfare of people and their democracies. Increasing financial volatility is negatively affecting people’s quality of life, even as high capital mobility is undermining their political power over their governments.

Financial Volatility
Today the daily volume of foreign exchange transactions is about $1600 billion after explosive growth in the 1970s and 80s, followed by slower growth of 9-12% throughout the 1990s.[i] If this high, yet historically slow growth rate continues, daily trading volume will be worth $6 trillion in 2010 and overtake the world GDP sometime in the early 2030s. Simultaneously, currency crises have been pervasive with 87 nations experiencing one since 1975.[ii] Moreover, the standard deviation of monthly changes in OECD exchange rates shows currencies have been three times more volatile since the 1960s. This has not been a constant variability, but contains significant volatility within wider fluctuations.[iii] It seems that free currency markets and floating exchange rates have not been as successful ‘buffer zones’ against instability as was originally predicted.

Volatility is not inherently bad, but it does tend to lead to several negative impacts on people’s quality of life. First of all, Sweder van Wijnbergen has found that unstable exchange rate policy by governments cause underinvestment because investors choose to wait until the uncertainty is over.[iv] Next, Aaron Tornell’s model demonstrates that unnecessary volatility from private capital transactions results in less-than-optimal real investment because investors choose to wait for stability to make permanent real investment.[v] Third, Aizenman and Marion show how uncertainty has a measurable negative effect on capital formation within a country.[vi] Finally, it must be remembered that financial crisis are simply volatility writ large. The more rate variance, the less investor confidence, and the greater the chance of financial crisis.[vii] All four effects of instability (underinvestment, decreased real investment, less capital formation, and financial crisis respectively) negatively impact the people’s economic well being, variously causing higher unemployment, insolvency, underdevelopment, budget shortfalls, and increased social need.

Status Quo Reactions Insufficient
The current measures to counteract this financial instability and its destructive impacts are not dependable. The first common countermeasure to instability has been more liberalization, because, as Milton Friedman said, if an exchange rate in a floating system is unstable “it is primarily because there is an underlying instability in the economic conditions governing the international trade,” of the country in question.[viii] IMF policy is based on this same theory and that organization reports that its “experience with member countries has shown that deeper and broader-based reforms are necessary to achieve high-quality growth.”[ix]

However, the remedy of liberal reform does not necessarily apply to capital markets. In fact, the original justification for free trade in goods and services was the immobility of capital, suggesting that freeing both is inconsistent.[x] This is bolstered by cases of financial crisis that are not readily explainable by a lack of market fundamentals. To cite one of many examples, the French franc was not overvalued against the mark by traditional macroeconomic measures such as inflation and interest rates in 1993, but capital flight forced the government to abandon its 2 1/4% margins nonetheless. In most cases econometric research has been unable to explain exchange rate movements using market fundamentals, especially for short-term periods.[xi]

The continued promotion of liberalization as a universal panacea to financial crisis, irrespective of evidence of its impotency, raises an important question. If the explanation for a crisis is always constructed after-the-fact, and if the perception of ‘real problems’ with an economy and investor reactions to them are not separable, then isn’t the explanation conceptually tautological? Assuming that all crises and instabilities are the result of departure from free market principals and then using the occurrence of these crises and instabilities as evidence of departure is entirely circular. We can no longer afford to blindly pursue Liberalization based on a fanatical faith in an assumed causation bolstered by epistemological conservatism. In fact, instability can have a host of causes, including the structure of capital markets, and methods for counteracting market distortion must be examined alongside more traditional returns to fundamentals.

Intervention by central bankers, attempts to “improve welfare through judicious introduction of another distortion,”[xii] and is the next standard weapon against exchange rate instability. Regardless of its effectiveness, this intervention is not a long-term option. Global official foreign exchange reserves have not kept up with the huge increase in daily foreign exchange trading, and the ratio of reserves to trading has been reduced to about 1:1, compared to the 15:1 of 1977. Reserves have grown in the 1990s to maintain the 1:1 ratio, but it will be impossible for reserves to keep up in the long-term if foreign exchange trading continues to grow at the historically low 12%. This means that even the now significantly reduced ability of monetary authorities to moderate and control exchange rate fluctuations will be ever decreasing in the years ahead.[xiii]

Another ‘judicious intervention’ has been unilateral capital controls by individual countries, such as those of Chile, Columbia, and Brazil. These were fairly successful at stabilizing exchange rates, preventing capital flight, and augmenting growth relative to other Latin American countries, and these limited successes with capital controls show that countries can choose to chart a course somewhat independent of global capital flows.[xiv] However, these controls are made significantly less attractive by the fear of sanction by the global financial system for defending regulations and taxing unilaterally. Most countries are too dependent on foreign capital to choose this strategy.[xv]
With the two standard forms of ‘stabilizing’ intervention into distorted markets lacking either longevity or universality, it seems the only long-term option for governments is to eliminate distortions through liberalization. However the Tobin Tax, or Currency Transaction Tax (CTT), offers an alternative to this conclusion.

Recommended Policy
John Maynard Keynes first proposed the idea of a government transfer tax on all transactions in 1932, with the goal of mitigating the predominance of speculation over enterprise in the United States.[xvi] In 1972, James Tobin internationalized this idea, by proposing a “uniform tax on all spot conversions of one currency into another, proportional to the size of the transaction,” and his name has stuck to it throughout many revisions.[xvii]

In 2000, Congressman Peter DeFazio and Senator Paul Wellstone introduced a concurrent resolution directing the US to enact “in concert with the international community, transaction taxes on short-term foreign exchange transactions.”[xviii] This administration should support that resolution domestically, and begin acting on its intent abroad. The specific CTT that we should advocate is delineated below.

The spreads in foreign exchange wholesale market are well below .1% for the major currencies, suggesting that a tax of .05%, which is at the extreme low end of most Tobin Tax suggestions, would be large enough to have a significant affect on trading.[xix] This rate would be paid whenever a bank or dealer engaged in a transaction with a retail customer. Wholesale transactions between banks or dealers will have the tax split between the two parties, to avoid double taxation.

Market Application- Broad
The primary realm of the CTT will be the spot market, however other markets will need to be taxed as well to prevent tax evasion through substitution.
Forward contracts will need to be taxed because a three-day forward contract is a very close replacement for a two-day spot contract. Swaps should be treated as a single transaction and taxed only once since they are mainly used by banks for covered interest arbitrage, and thus very sensitive to small price increases. Futures should also be taxed, because they can be close replacement for forwards when settled by actually delivering the currencies involved. These should be taxed when written and when traded, as if they were a spot purchase and subsequent sale. Options also need to be taxed as well to avoid their use as substitution for futures, especially when they involve actual delivery of the currencies in question.


Location- Dealing Sites
Settlement, Booking, and Dealing sites are the three possible locations for assessing a CTT. Too many foreign exchange transactions are netted before they are settled for settlement sites to be a viable option. Additionally, inter-bank transfers of foreign currencies (such as the purchase of Japanese securities from a US bank with yen by another US bank) cannot currently be distinguished from foreign exchange transactions at settlement sites. Booking sites should not be used because they are very evasion prone– banks would be able to avoid taxation merely by putting computers in tax-free jurisdictions. Taxation at dealing sites however, would mean that to evade taxation banks would have to move their dealing rooms and dealers to the tax haven, which makes evasion much more costly.


Collection- Domestic Basis
Country governments will collect all transaction taxes, appropriating some for themselves, and transferring the rest to the CTT regulatory agency. There are two possible ways for them to collect these taxes: on a national or a domestic basis. The national method (under which the head office of each bank would collect and consolidate data from every one of its dealing sites and pay the CTT to the banks home country) has the advantage of making it impossible for banks to avoid taxation by setting up dealing sites in tax-free locations. However, it would also impose large burdens on banks to collect data. Governments could make their country a tax haven by conferring confidentiality on individual foreign exchange transactions. Countries would be able to give their national banks a competitive advantage by refusing to implement the tax.

In contrast, the domestic approach would be much more advantageous. The risk of bank migration to tax-free locations grows, but governments have little incentive to confer tax freedom since their national banks would not benefit (as they are still being taxed in other countries), and their country would benefit only indirectly through job creation and rising property values. Moreover, a market basis gives countries like Singapore and the U.K. with large foreign exchange markets, but smaller national banks an incentive to join a CTT regime: more tax revenue.


Enforcement
The CTT must include a punitive tax for transactions with tax-free trading sites that is high enough to render the decision to evade uneconomical, such as 5% (as opposed to the normal .025% tax on wholesale trading). This gives banks a strong incentive not to be the first bank to set up a dealing site in a tax-free jurisdiction, as no other bank would be willing to trade with them. However, this measure would lose its effectiveness with every bank that decided to migrate, and would do nothing to prevent migration to established dealing sites that don’t join a CTT regime.

This means that a necessary condition to this agreement is the participation of all of the countries with the largest foreign exchange markets- the EU, US, Japan, Singapore, Switzerland, Hong Kong, Australia, and Canada. Additionally, an international agency must be chosen or created to draft a specific tax code going far beyond the suggestions above, interpret and amend the code in the future, and collect the part of the tax revenue that is reserved for international purposes. The IMF has been suggested for this role, however it may be better to create a new organization that would not have its own policy goals to pursue with the international tax revenue it stewards. [xx]

CTT Effectiveness at Mitigating Instability/Dangers of the Status Quo
Specific policy choices incorporated into a CTT system (like the ones outlined above) have the ability to overcome most technical objections to feasibility. However, the overall effectiveness of a CTT is dependent on two key factors: one, the extent to which short-term investors are a significant cause of financial volatility and two, the ability of a CTT to discourage short-term investors.

Causes of Financial Volatility
Several causes for financial instability have been suggested that are not related to illiberal country policies: moral hazard, speculation, and multiple equilibria.

Moral hazard’ means that government insurance of investor liability encourages investors to take greater risks, creating market distortions and exchange rate instability. The unwillingness of governments to write-down the debt following the 1982 debt crisis assured institutions that the government would provide free equity if the investments went bad, as Kane shows.[xxi] Mathieson and Rojas-Suarez demonstrate that “institutional failures can be created by this mispricing of risk” and suggest improved systems of prudential supervision.[xxii] Akerlof and Romer reveal how exchange risk provides a vehicle for investors to exploit government insurance in developing countries.[xxiii] The riskier positions that investors take based on insurance create an exchaneg rate divorced from market fundamentals- an inherently unstable rate.

Speculators seem to cause significant amounts of financial volatility simply based on the distribution of exchange rate changes- for example the fact that exchange rates are more unstable when trading is open and private information has influence over rates.[xxiv] Moreover, Ito and others show that this information is about more than market fundamentals[xxv] while Meese provides data-based evidence that exchange rates are partially determined by bubbles.[xxvi] Flood, Rose, and Mathieson dispute this and suggest that the evidence for bubbles is weak.[xxvii] However, in another work, Flood and Rose demonstrate a pattern of increased nominal and real exchange rate variability whenever there is a shift from a fixed to a floating rate regime, despite a reduction in the variability of fundamentals to keep the exchange rate stable.[xxviii] The standard explanation for these discrepancies, ommitted fundamentals, is unfalsifiable and does not stand up to the growing body of evidence that the foreign exchange market is partly driven by rational speculative bubbles.

A third cause of financial volatility is the existence of multiple stable exchange rate equilibria, which lead to self-fulfilling speculative attacks. Basically, changes in government policy that are expected to prevail after a successful attack can generate a successful speculative attack, even if the government follows pre-attack policies that are consistent with no future change in policy, as proven by Flood and Garber.[xxix] Eichengreen and Wyplosz demonstrate how this occurred in the early 1990s when the benefits of membership in the European Economic Union made it rational for governments to follow tight monetary policy. However, successful attacks made membership in the first round impossible (since a stable currenency for two years prior to membership was required) making it rational for authorities to relax their monetary policy. The speculative attack generated the subsequent government behavior to rationalize the attack.[xxx]

Short-term Investors
All these causes of financial volatility- moral hazard, speculators, and multiple equilibria- are triggered by short-term investors.

Though the most obvious examples of moral hazard leading to riskier investment involve long-term investment, such as loans by banks, institutional short-term investors are significantly to blame. Frankel and Rose provide evidence that short-term investors are the most likely to take greater risks due to government insurance, and that successful speculative attacks are much less likely to occur in countries with a high proportion of long-term direct investment flows.[xxxi]

Frankel also uses surveys of foreign exchange traders to demonstrate that, were they to act on their extrapolations of future price, short-term investors would create bubbles. His data shows that when market participants extrapolate prices in horizons of less than three months they create upward blips, leading to expectations of future appreciation, contributing to the upward trend. When horizons are three months to a year this upward trend is not present and action by traders leads to a stabilized exchange rate.[xxxii] This does not inherently mean that short horizons determine market prices because it would be rational for traders’ short-term expectations of currency worth to be constrained by their long-term forecasts. However, survey data also shows that short-term expectations of traders are not in fact limited or affected by their long-term calculations.[xxxiii] Given that most currency trading takes place in a horizon of under one day, short-term expectations are definitely dominant and are causing rate volatility.[xxxiv]


Causes of excessive Capital Mobility—solvency (missing) link
-nature of capital
-market structure
-eliminating short term would mitigate


CTT produce large disincentives to short-term transactions
If the rate of return at home is i percent a year, then the required foreign rate of return i* is dependent on the Tobin Tax, t, and on the years, y, for which the foreign position is kept. Thus for round-trip foreign investments to be as profitable as domestic investment:

(1 + i*y)(1 – t) – t = 1 +iy

and therefore the foreign rate of return must be:

i* = (i + 2t/y)/(1 – t)

This means that investors are increasingly penalizes as their horizon shrinks. For example, assume that the domestic interest rate is ten percent and the Tobin Tax is set at one percent. For a one-year investment, foreign yield would have to be at least twelve percent to attract investors. For a one-month investment horizon, foreign yield would have to be thirty-four percent. For a one-week investment, foreign yield would have to be one hundred and fifteen percent.

Since those profit margins are unlikely to occur, the CTT effectively stops these trades from happening.


Endnotes

[i] Bank for International Settlements. Central Bank Survey of Foreign Exchange and Derivatives Market Activity 1998, Basle: BIS, 1999. Tables A-3, B-2, B-3, B-8.

[ii] Joseph E. Stiglitz. Lecture. “Must Financial Crises be This Frequent and This Painful?” Pittsburgh, Pennsylvania. 23 September 1998 <http://www.worldbank.org/html/extdr/extdr/extme/js-092398/index.htm>

[iii] Malcolm Edey and Ketil Hviding. “An Assessment of Financial Reform in OECD Countries.” OECD Economics Department Working Papers 154, OECD/GD. 1995.

[iv] Sweder van Wijnbergen. “Trade Reform, Aggregate Investment and Capital Flight.” Economic Letters 19.4 (1985): 369-72.

[v] Aaron Tornell. “Real vs. Financial Investment, Can Tobin Taxes Eliminate the Irreversibility Distortion?” Journal of Development Economics. 32.2 (1990): 419-44.

[vi] Joshua Aizenman and Nancy P. Marion. “Macroeconomic Uncertainty and Private Investment.” Economic Letters. 41.2 (1993): 207-10.

[vii] Heikki Patomaki. Democratising Globalization: The Leverage of the Tobin Tax. London: Zed Books, 2001. 29-31.

[viii] Milton Friedman. “The Case for Flexible Exchange Rates.” Essays in Positive Economics. Ed. Friedman. Chicago: University of Chicago Press, 1953. 173.

[ix] International Monetary Fund. Annual Report 1998. Washington: IMF, 1998. Box 2.

[x] Herman E. Daly and John B. Cobb Jr. For the Common Good: Redirecting the Economy Towards Community, the Environment, and a Sustainable Future. Boston: Beacon Press, 1989. 213-8.

[xi] Richard Meese and Kenneth Rogoff. “Empirical Exchange Rate Models of the Seventies.” Journal of International Economics. 14: 3-24.

[xii] Michael P. Dooley. “The Tobin Tax: Good Theory, Weak Evidence, Questionable Policy.” The Tobin Tax: Coping with Financial Volatility. Eds. Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg. New York: Oxford University Press, 1996. 85.

[xiii] David Felix. “Financial Globalization versus Free Trade: The Case for the Tobin Tax.” UNCTAD Discussion Papers 108. Geneva, 1995. 16.

[xiv] Manuel R. Agosin and Ricardo Ffrench-Davis. “Managing Capital Inflows in Latin America.” The Tobin Tax: Coping with Financial Volatility. Eds. Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg. New York: Oxford University Press, 1996. 161-85

[xv] Patomaki, p. 171-2.

[xvi] John Maynard Keynes. The General Theory of Employment, Interest, and Money. London: Macmillan, 1932. 158-60.

[xvii] James Tobin. “A Proposal for International Monetary Reform.” Eastern Economic Journal. 4.3-4 (1978): 155.

[xviii] United States. Cong. “U.S. Congress Concurrent Resolution on Taxing Cross-border Currency Transactions to Deter Excessive Speculation.” H. Cong. Res. 301. 11 April 2000.

[xix] Morris Goldstein, David Folkerts-Landau, Peter Garber, Liliana Rojas-Suarez, and Michael Spencer. International Capital Markets: Part I. Exchange Rate Management and International Capital Flows. Washington: International Monetary Fund, 1993. 59.

[xx] Peter B. Kenen. “The Feasibility of Taxing Foreign Exchange Transactions.” The Tobin Tax: Coping with Financial Volatility. Eds. Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg. New York: Oxford University Press, 1996. 109-22.

[xxi] Edward J. Kane. The Gathering Crisis in Federal Deposit Insurance. Cambridge: MIT Press. 1995.

[xxii] Donald J. Mathieson and Liliana Rojas-Suarez. “Liberalization of the Capital Account, Experiences and Issues.”: IMF Occasional Paper 103. Washington: IMF. 1993. 343-4

[xxiii] George A, Akerlof and Paul M. Romer. “Looting: The Economic Underworld of Bankruptcy for Profit.” Brookings Papers on Economic Activity. 2 (1993): 1-60, 70-4.

[xxiv] Dooley, p. 87.

[xxv] Takatoshi Ito, Richard K. Lyons, and Michael T. Melvin. “Is There Private Information in the FX Market? The Tokyo Experiment.” Mimeo. January 1996.

[xxvi] Richard Meese. “Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?” Journal of Political Economy. 94 (1986): 345-72.

[xxvii] Robert P. Flood, Donald Mathieson, and Andrew K. Rose. “An Empirical Exploration of Exchange Rate Target Zones.” Carnegie-Rochester Conference Series on Public Policy 35 (1991): 7-65.

[xxviii] Robert P. Flood and Andrew K. Rose. “Fixing Exchange Rates.” Working Paper 4503. National Bureau of Economic Research, 1993.

[xxix] Robert P. Flood and Peter M. Garber, “Gold Monetization and Gold Discipline.” Journal of Political Economy. 92.1 (1984): 90-107.

[xxx] Barry Eichengreen and Charles Wyplosz. “The Unstable EMS.” Brookings Papers on Economic Activity. 1 (1993): 51-143.

[xxxi] Jeffrey A. Frankel and Andrew K. Rose. “Currency Crashes in Emerging Markets: An Empirical Treatment.” Board of Governors of the Federal Reserve System, IFDP 534. Washington: GPO. 1996.

[xxxii] Jeffrey A. Frankel. On Exchange Rates. Cambridge: MIT Press, 1993. 324.

[xxxiii] Jeffrey A Frankel. “How Well Do Foreign Exchange Markets Function: Might a Tobin Tax Help?” Working Paper 5422. National Bureau of Economic Research, 1995. 17-8.

[xxxiv] Norman Fieleke. “Foreign-Currency Positioning by US Firms: Some New Evidence.” Review of Economics and Statistics. 63.1 (1981): 35-42.

Leave a Reply

You can use these HTML tags

<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>