Desirability and feasibility of Tobin Tax and beyond

Mr Moderator and Distinguished Panelists, 

I am thankful to the Global Progressive Forum for inviting me to the “first seminar of the Europeans for Financial Reform”, and to be a panelist on “Fighting for a Financial Transaction Tax – how and why?” in Brussels. 

As the preamble to the program states “although there is an unprecedented groundswell of support for the FTT – among citizens, civil society and progressive politicians – this has not been mirrored by concrete action at G20 level”. I agree with the view that this subject, Financial Transaction Tax, deserves more attention than what it received so far, and is likely to gain greater support, as the underlying causes of the global financial crisis are fully appreciated. 

My interaction with the subject has been brief but eventful. More than 5 years ago, on January 1, 2005, I had given a speech on Indian economy. In the context of management of capital account, I had mentioned that “price based measures such as taxes, could be examined, though their effectiveness is arguable”. There was strong reaction from the participants in financial markets that the Governor was advocating Tobin Tax, and that it was totally undesirable. The adverse reaction of financial markets was swift and severe. Immediately, the Finance Minister had to soothe the markets, after discussing with me, with an assurance that no such proposal for taxes was under consideration of the Government. However, that was not enough to cool the anger of the financial markets and also the nervousness in public policy circles. Hence, a clarification had to be issued from the Reserve Bank of India that such a tax may not be desirable. The atmosphere governing the thinking on Tobin Tax seems to have changed since then, though there is no evidence that the sentiments of financial markets on the subject have altered. It is, therefore, of great personal interest for me to revisit the subject with a sense of freedom and hind-sight. 

Objectives of Tobin Tax: 

American Economist, James Tobin, first made the suggestion for a tax on currency transactions to dissuade shorter currency speculation in the 1970s. He made the suggestion with two main objectives, viz., (a) to make exchange rates reflect to a larger degree, long run fundamentals relative to short-run expectations and risks; and (b) to preserve and promote autonomy of national macro-economic and monetary policies. It is essential to constantly revisit the relevance of the objectives in considering both the desirability and the feasibility of Tobin Tax. In fact, the underlying approach of taxing transactions has the potential to be applicable to not only currency markets, but other markets as well, particularly after the experience in regard to global financial crisis. 

The levy of Tobin Tax has been a subject of policy debates amongst politicians, economists and panelists, since it was mooted. During the debate, Professor Tobin seems to have agreed with some of the arguments relating to difficulties of implementing such a tax. At an international level, however, Tobin Tax gained some popularity in view of its potential for funding of global public goods. There has been notable support, particularly in the United Kingdom and Euro areas, and also among civil society organizations for such a levy to fund global public goods addressing climate-change and poverty issues. 

After the global financial crisis approach to the Tobin Tax has assumed greater urgency and relevance. Firstly, such a tax is considered necessary to recover the bailout cost incurred by the Government to avoid collapse in the financial sector. Secondly, the ill-effects of excessive financialisation have been realized now. The volume of Foreign Exchange transactions is $ 2,000,000,000 ($ 2 Trillion) a day, while only 5% of this is necessary for financing trade in goods and services. Thirdly, the impact of excess volatility in financial markets on the rest of the economy is better appreciated now. It is now argued that the ill-effects of volatility and risks of volatility are inherent in all financial markets and not in currency markets only. Lord Turner of U.K. noted that several parts of the financial sector growth are in excess of socially desirable levels. Fourthly, some of the developing countries have found it necessary to moderate the capital flows through use of several instruments, of which Tobin Tax type is one of the measures undertaken. In view of the emerging uncertainties, the developing economies find greater appeal in such options. Finally, Gordon Brown, the Prime Minister of U.K., placed this issue formally on the table of global agenda in the meeting of G-20, in November 2009. It was mooted as part of “a better economic and social contract between financial institutions and public”. Four possible reforms were proposed as part of such a contract and one of them is financial transactions tax. Several economists, including some of the Nobel Prize Winners in Economics, have become active proponents of a tax on financial transactions including the tax on currency transactions. 

The desirability of Tobin Tax has, however, been questioned on several grounds. (a) It is not possible to differentiate between the “real variables” driving exchange rate such as gross domestic product employment, output and “unreal ones” that create speculative bubbles; (b) The Tobin Tax creates economic distortions to the market mechanisms; (c) It is better to improve underlying policies and environment which generate such volatility in financial markets, rather than impose a tax; (d) Such a tax increases transaction costs, but such a tax is likely to be small, relative to the expected profits out of the market activity. Hence, volatility may not be curtailed by such a tax and it is possible that volatility may even be enhanced; (e) All short-term capital movements may not be bad, and some of them may be good for efficiency in markets; and (f) The revenue yield from such a tax is highly uncertain. 

It is essential to approach the underlying principles behind the arguments against the desirability of Tobin Tax. Their assumption is that the financial markets always play a useful role in reflecting the fundamentals and they should be left to do it with minimum friction. They hold that any attempt to interfere with the market mechanisms is likely to be inefficient and ineffective. They argue that in any case, it is difficult for non market authorities, including public policies, to make a judgment on the speculative and non-speculative factors as also the existence of or excess volatility. 

Clearly, the experience of global financial crisis makes it difficult to continue with such beliefs especially after the massive intervention of public policy to save the financial markets. Under the circumstances, at the current juncture, the main arguments of those who oppose taxes such as Tobin Tax are based on non-feasibility and sometimes acceptance, purely as a temporary measure to get over the crisis. 

The arguments of non-feasibility of Tobin Tax are – (i) It is difficult to get international consensus on such a tax; (ii) It is difficult to estimate the revenue from such a tax and agree on the distribution of proceeds between sectors and countries; (iii) Enforcement of such a tax is difficult; (iv) There may be an incentive for some countries to opt out of the regime and attract financial sector activities to its territory since currency can be treated anywhere; (v) The financial markets are fully integrated and hence it is possible for the financial markets to avoid the burden of tax through financial innovation. 

Those who argue that such a tax is feasible, advance several reasons, such as, (1) The statement that the underlying policies that generate volatility should be addressed assumes that there are other instruments which, by themselves, can moderate excess volatility. No convincing set of such measures are identified; (2) 84% of gross currency transactions take place in only nine countries, and hence agreement is not too complex; (3) Settlement in currency markets is centralized or centrally overseen. Hence, tracking of the trades is feasible; (4) The Information Technology (IT) infrastructure enables effective imposition as well as monitoring of such transactions; (5) There are international agreements on very complex matters relating to finance. For example, money laundering which happens on a cross country basis also is extremely difficult to implement or monitor, but there is a determination and effort to deal with money laundering issues on a global basis; (6) G20 has already initiated concerted action over the last year on tax havens and non compliant jurisdictions. Hence, it should be possible to work on a Tobin Tax through an international agreement backed by national legislation. The agreement could cover transactions where the deal is made and where transactions occur. 

A close examination of the arguments about feasibility would indicate that they reflect difficulties of cross border cooperation in matters of currency markets. However, it is interesting that cross country coordination of public policy was achieved to avoid a collapse in financial markets at short notice. These included broad monetary measures, market intervention and bailout of institutions. If cross-country cooperation in public policy is feasible when it suits the financial markets, it should be possible, if there is a political will, to continue with such cooperation, in larger public interest. It can also be argued that laws relating to theft are not effective because most of the activity relating to theft goes unpunished. Yet, laws of theft do exist, and serve a purpose. In other words, if the desirability is established, then the feasibility has to be explored with a view to implement it. In fact, it may be argued that some countries may consider imposition of taxes similar to Tobin Tax unilaterally. It is difficult to deny that the incentive to multiply financial transactions of a short-run nature is reduced by such a tax. The profitability for those who are engaged in such transactions is also reduced by the imposition of such taxes. 

It is sometimes argued that measures such as Tobin Tax are not effective over the long run, but may be useful in the context of a crisis. The objective of Tobin Tax is clearly to prevent the eruption of volatility and, therefore, to argue that it should not be taken up before the event is somewhat surprising.

It will be useful to briefly review the experience in regard to such taxes, or measures which have the effect of such a tax. A quick review of the literature available on the subject leads to some very general observations, viz., (a) Experience of Thailand has not been very positive in terms of realizing the objectives. However, it may be argued that adequate determination of public policy to implement the measures to curtail inflows including tax was not evident. In any case, the possible volatility in the absence of such measures is difficult to assess. (b) In Columbia, the capital controls reduced external borrowings, but the overall impact is not clear. (c) In Chile, there has been a reduction of short-term flows and some injunction of stability, and to that extent, the taxes may be considered partially effective. However, quasi-fiscal losses, lower investment and growth cannot be ruled out. (d) In Malaysia, the intended results were obtained on all fronts. It is noteworthy that there was a display of determination of public policy in intervention and coordination of several policies. (e) In Brazil, it is still early to draw conclusions, but the tax appears to have achieved some of its intended results according to the Institute of International Finance. (f) Both, China and India, have taken recourse to several measures which have had the effect of Tobin Tax in some ways. The empirical evidence in terms of stability and longer term growth is noteworthy. 

While it is difficult to generalize, cross country analysis made so far seems to indicate that capital account management, in particular measures like Tobin Tax, has the effect of dampening of flows in the short-run. There is some change in the composition of flows towards longer term. The non financial direct investment is relatively unaffected. The longer term implications on growth are not easy to assess. Often, these measures had been undertaken in the context of a crisis, and it is difficult to judge the position, if these actions had not been taken. In brief, there is no evidence of serious downside risks of capital account management and recourse to Tobin Tax. 

It may be useful to review in this context the variety of taxes on transactions in financial sector that are existing. These taxes vary between different countries. An examination of these taxes would show that distortionary adverse effects of such taxes on efficiency of financial sector or profitability of financial sector should not be assumed. Stamp duties are out-dated, but they are not inconceivable. In many countries, there are financial transaction taxes (including on repos, swaps, etc.), and there are also turnover taxes on financial institutions. There are value added taxes on financial sector. Taxes on bank debits and credits are not uncommon. In brief, such taxes, similar to Tobin Tax, are in vogue in a wide variety of national jurisdictions including China, Philippines, Argentina and Israel. There are also proposals for with-holding taxes of all profit capital inflows. 

To conclude, it is essential to address the issue of excessive reliance on market mechanisms and, in particular, the excessive growth of financial sector. Hence, there is considerable merit in countries insisting on keeping the option of levying taxes on all financial transactions as a matter of public policy. Such a tax may ideally cover several financial markets and, in particular, currency markets. A tax regime in position even with nominal rates would be advisable so that the financial markets are aware of the instrument at the command of public policy and willingness to use it. The experience in regard to benign neglect of asset bubbles in the recent crisis and preference to counter-cyclical policies provides logic for putting in place mechanisms similar to Tobin Tax on a continuous basis. The measurable downside of such taxes appears to be negligible. While it is held that Tobin Tax may be ineffective, it has never been the case that it has toxic potential such as financial innovations. It is true that revenue is uncertain, and it is also true that international agreement on such taxes and distribution of such revenues are difficulties, but difficulties have not deterred cooperation in many initiatives. The case for Tobin Tax is well established now to meet the objectives set by Professor Tobin and revenue is an additional attraction. It cannot be the case that Tobin Tax by itself would be effective, but it has immense potential when the instrument is used along with complementary policies, in particular, counter-cyclical and macro-prudential measures. A review of the existing taxes at national level in some jurisdictions would point to the feasibility of such taxes at national level. International coordination for levy of such taxes must be pursued vigorously, but national level initiatives for Tobin Tax as part of measures to achieve financial stability by individual countries also has much to commend for itself. It is undeniable that globally coordinated action will enhance the effectiveness of policies at national level.