A NEW PROPOSITION FOR THE TOBIN TAX A report by Sony Kapoor for The Tobin Tax Network July 2004 The Currency Transaction Tax enhancing financial stability and financing development produced with support from A NEW PROPOSITION FOR THE TOBIN TAX The Currency Transaction Tax enhancing financial stability and financing development A report by Sony Kapoor for The Tobin Tax Network July 2004 with support from ENHANCING FINANCIAL STABILITY AND FINANCING DEVELOPMENT Contents Foreword 3 Executive summary 5 Introduction 9 1 The foreign exchange market 13 2 Our currency transaction tax (CTT) proposition 15 3 CTT: a radical proposal or a mainstream idea? 19 4 The CTT: raising revenue, decreasing volatility and reducing the likelihood 21 of currency crises 5 Benefits of the CTT for the world economy and sovereign states 23 6 The business case for the CTT 29 7 The social and economic consequences of a currency crisis 33 8 The Millennium Development Goals and financing international development 35 9 CTT progress and next steps 37 10 Responding to criticisms of the CTT 39 Appendices 45 I The foreign exchange market 45 II Our proposal for the CTT 51 III The CTT is a mainstream idea 59 IV The CTT: decreasing volatility and reducing the likelihood of currency crises 65 V The opportunity costs of holding foreign exchange reserves 79 VI Responding to criticisms of the CTT 85 VII The Millennium Development Goals 89 VIII The Tobin Tax Network position paper on the International Finance Facility91 Frequently asked questions 97 Glossary 105 Bibliography 111 © TOBIN TAX NETWORK 2004 1 THE CURRENCY TRANSACTION TAX 2 © TOBIN TAX NETWORK 2004 ENHANCING FINANCIAL STABILITY AND FINANCING DEVELOPMENT Foreword The Tobin Tax The idea of taxing the trade in currencies was first suggested by Nobel prize-winning economist, James Tobin. This is why the currency transaction tax (CTT) is often referred to as the Tobin Tax. Today’s CTT proposition is for a variable tax with two different rates. A very low rate used in normal market conditions that would generate substantial revenues for international development and a very high rate employed at times of exceptional volatility to prevent financial shocks and create greater economic stability. A few weeks ago Belgian parliamentarians made a historic vote in their Assembly when they passed legislation for a currency transaction tax (CTT). More than 30 years since James Tobin first proposed the concept of taxing the currency trade, the tax that popularly bears his name is now widely known by politicians, financial journalists and millions of people across the world. Yet it has taken until this time to be expressed in such a form that is both technically feasible and politically acceptable. This is the breakthrough the Belgian legislation represents. The purpose of this report is to detail how the present CTT proposition is not only possible but eminently desirable. From the world’s poorest communities, who would benefit from the revenue it can generate, to the world’s business community, who would benefit from far greater market stability, it is clear that the advantages of a CTT are so considerable that failure to make progress along this road would be very costly. We have designed this report to be easily accessible to various audiences. The main body is comprised of very concise chapters. If a reader would like to go deeper into the background of the conclusions, they will find more detailed research and analysis presented in the appendices. The report also contains a comprehensive ‘frequently asked questions’ section and a glossary. Since James Tobin first presented his tax on currency trading, the market in foreign exchange has expanded one hundred times. It is not surprising, therefore, that his original concept has been seriously modernised to fit with today’s market conditions. In this respect, we acknowledge the important work of German economist Paul Bernd Spahn, who developed the idea of a two- tier Tobin Tax that lies at the heart of our CTT proposition. Our report builds on the foundations laid by Spahn, improving certain aspects by drawing on the expertise of academics and finance professionals. James Tobin’s great idea was to tax the trade in currencies. We believe that with this report we can show how a modern version of his concept is now not only possible but makes absolute sense in order to create a more stable financial environment for business, for trade, for employment and to generate urgently needed revenue to benefit the world’s poor. About the Tobin Tax Network The Tobin Tax Network is a coalition of more than 50 charities, campaign agencies, faith groups and trade unions set up at the end of 2001 to campaign for the currency transaction tax. The combined memberships of all these organisations number many millions of UK citizens. © TOBIN TAX NETWORK 2004 3 THE CURRENCY TRANSACTION TAX 4 © TOBIN TAX NETWORK 2004 ENHANCING FINANCIAL STABILITY AND FINANCING DEVELOPMENT Executive summary How is the market organised? The currency market is the largest market in the world, with a turnover of US$300,000 billion every year. It is loosely regulated and, despite its size, is highly concentrated. Most of the trading is carried out by about 30 large banks trading mostly G7 currencies in eight major locations. How are exchange rates determined? The price at which one currency can be exchanged for another is not constant but varies in response to changes in inflation, interest rates, unemployment and other economic factors. It is also influenced by other factors, such as speculation and market psychology, which affect the supply and demand for a currency. Surveys1 of currency traders show that economic fundamentals are relatively unimportant in trading decisions up to a six-month horizon. Since more than 90% of market transactions have a time horizon shorter than six months, it follows that most currency trading decisions do not reflect the true underlying economic value. As a consequence, exchange rates do not reflect the true relative strengths of economies and can lead to bad investment decisions. More than 75% of currency traders believe that speculation is the single most important reason why currency values do not reflect economic fundamentals. What is currency volatility? Though major economic variables change relatively infrequently, it is common for exchange rates to change up to 100,000 times in a single day. 2 While most of these changes are small, they can sometimes add up to as much as 20% or more over the span of weeks or even days. Currency volatility is a measure of this change in the price of a currency. The larger and the more frequent the fluctuations in the exchange rate, the higher the currency volatility. When this volatility is very high, involving several large changes in prices, it causes instability in the financial system. How does currency volatility affect us? Financial instability is one of the most serious problems currently confronting the world. High volatility in financial markets, even when it does not lead to spectacular crashes of the kind seen in South East Asia in 1997–8,3 carries high social and economic costs. It acts as a tax on trade, investment, social welfare and growth and can undo in days what has taken years of development effort to achieve. 1 From surveys of currency Currency instability is by far the most pernicious form of financial volatility because of the traders by Cheung et al, 2000; Cheung Y and Chinn MD, severity of its impact. While excessive volatility in the stock or the bond markets is harmful, 2000; Hutcheson T, 2000. See Appendix IV damage is limited to certain sectors of an economy and the people associated with those 2 Bloomberg sectors. Instability in the currency markets, on the other hand, affects all aspects of the 3 See www.ids.ac.uk/ids/global economy and can have disastrous effects on millions of people. /Finance/easia.html © TOBIN TAX NETWORK 2004 5 THE CURRENCY TRANSACTION TAX How does currency volatility come about? Currency instability does not arise because of the actions of ‘evil speculators’ but is a natural outcome of the incentive structure built into the market. The actions of a limited number of currency traders just doing their jobs can inflict damage to whole economies and have ruinous consequences for their populations. What can we do to reduce currency volatility? When the actions of a few can affect the welfare of many, there is a strong justification for public policy intervention. However, there are many who believe that ‘markets know best’. There is a way of striking a compromise between the two beliefs, using a market-based solution. The currency transaction tax changes the incentive structure in the market and works by discouraging instability-causing behaviour amongst currency traders. While there have been various proposals for a tax in the past, they have either been impractical or incomplete. Both by building on the work done by others and using our own original research, we have proposed a comprehensive, pragmatic and feasible version of a currency transaction tax that would stabilise the currency markets. It would also reduce the occurrence of the kind of currency crashes that were seen in South East Asia, Mexico, Russia and Brazil. What is our currency transaction tax (CTT) proposal? Our proposal for a CTT is a market-based mechanism which, by changing the incentive structure in the market, helps discourage excessive speculation and encourages traders to give greater importance to economic fundamentals. It comprises a very small (0.005%) tax that will be levied on all exchange transactions in a particular currency and a higher variable tax that will apply only in highly volatile markets and act as a circuit breaker to stabilise markets.