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Chapter 1: Motivation What Is the Purpose of a Tax on Foreign Exchange Transactions?

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Chapter 1: Motivation What Is the Purpose of a Tax on Foreign Exchange Transactions? Chapter 1: Motivation What is the purpose of a tax on foreign exchange transactions? The proposal of a tax on foreign exchange transactions goes back to Tobin (1972).1 It has repeatedly being discussed, but realization is still pending.2 The discussion of the Tobin tax is however motivated by extremely different objectives. The more important ones are the following: » The reduction of exchange-rate volatility through „throwing sand into the gears“ (Tobin) of world financial markets. This includes two sub-elements 3: ü A greater reorientation onto economic fundamentals, and ü the freedom of central banks from being compelled to intervene in foreign exchange markets in order to stabilize their currency. » Fiscal motives. These may be divided into two: ü The mere exploitation of new revenue sources, and ü an indirect approach to taxing globalized capital income in view of difficulties to tax them under a national income tax. » The redistribution of resources, in particular among the North and the South, as well as the symbolic association of the tax with principles of social justice. » Expectations of controlling or altering the process of globalization through constraints imposed onto the international financial system. 1 Tobin presented his proposal initially in 1972 in his Janeway Lecture at the University of Princeton; it was published in 1974 as The New Economics One Decade Older, pp. 88-92. Tobin has repeated his proposal several times such as in Tobin (1978, 1984, 1991, 1996) and Eichengreen, Tobin, and Wyplosz (1995). In recent discussions with the author, Tobin has retained his proposal although he distances himself from groups that usurp his concept as a mean to combat globalization. 2 However the French Parliament has enacted a Tobin tax in 2001 (Loi de finances pour 2002 - n° 3262, Art. 986. I), though it hinges on all other member states of the European Union adopting such a tax. 3 Tobin (1996, pp. xii-xiii) One cannot expect that only one pol- other. This ni creases the tax burden icy instrument—such as the Tobin on frequent short-term currency trad- tax—could realize all these objectives ing compared to longer-term invest- at the same time. First it is to be dis- ments in foreign currencies. According cussed, which objectives are at all re- to Tobin this would reduce an erratic alistic, and in which form a tax on for- volatility of the exchange rate because eign exchange transactions could traders would again be forced to focus achieve their realization. on fundamental data instead of being seduced by transient market senti- ments (Tobin (1991), p. 16). The idea » Stabilization of exchange rates. is to limit short-term capital move- The reduction of exchange rate volatil- ments without hindering international ity was Tobin’s original intention of the trade in goods and services, and di- tax. He argued before the background rect investments. of a collapsing fixed-exchange-rate regime (Bretton Woods) that had re- peatedly led to speculations against Table 1: the US dollar. At the time the dollar Foreign interest (in percent) required was the almost exclusive world cur- to match a domestic investment with rency. There were only three motives a 5-percent return (for different tax rates) to exchange dollars as the interna- Required tional mean of payment against na- Holding foreign interest rate tional currencies, two of them „honor- period able“ (for financing exports/imports of in percent goods and services, and of direct in- Tax rate 0.5 pc 0.1 pc vestment) and one questionable: for speculation. One day 541.3 50.7 The idea to reduce speculation in fi- Three days 92.6 18.5 nancial markets through taxation goes One week back to Keynes (1936). Keynes com- 37.0 10.7 pared speculative activities to casino One month 12.1 6.4 operations and argued that "...casinos should, in the public interest, be inac- Three months 7.7 5.5 cessible and expensive" (p. 159). One year 6.1 5.2 Tobin transposes this idea onto for- eign exchange markets where he Five years 5.6 5.1 wants to throw "sand in the wheels" in the form of financial transactions taxes. More specifically Tobin sug- The main advantage of the tax is in- gests an international and multilateral deed that it can target short-term cur- tax on all spot transactions from one rency transactions very effectively. currency into another, which is propor- The differential impact of the tax on tional to the size of the transaction short- and long-term transactions can (Tobin 1978, p. 490). Initially he be expressed arithmetically and is thought that a uniform tax rate of one shown in Appendix 2. The formula al- percent would be appropriate, but lows calculating the interest rate on more recently he changed his pro- foreign investments required to match posal by reducing the rate to about a domestic investment in spite of the 0.25 to 0.1 percent (Tobin 1996, p. tax. For instance, if the interest rate is xvii). 5 percent for a domestic investment and the tax rate on currency transac- The tax would be due every time a tions is 0.5 percent (0.1 percent), the currency is exchanged against an- foreign interest rates required for ef- Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 2 fective arbitrage between two cur- tem. Today the predominant part rency areas for different holding peri- of currency transactions consists ods is exhibited in Table 1. of liquidity trading among financial institutions. This serves primarily It is clearly shown that the required for hedging against exchange-rate foreign interest rate must be the risks, which is essentially stabiliz- higher, the shorter the holding period ing. It is extremely rare that liquid- of the foreign investment becomes. ity is also used for speculative This is the essence of Tobin’s argu- 6 purposes. A tax on currency ment: the tax would encumber short- transactions would primarily hurt term speculative transactions more liquidity trading and thus jeopard- heavily than longer-term foreign in- ize the functioning of the world fi- vestment that would essentially be de- nancial system. termined by fundamental data. » A comparison of net interest rates Ideally financial transactions associ- between currency areas—as ated with direct foreign investments shown in Table 1—does not fully and the trade of goods and services 4 describe the impact of taxation on would be exonerated from the tax. speculation. Speculators act with a However this requires substantial ad- very short-term perspective. For ministrative “red tape”, which would instance, if an investor expects a certainly favor evasive practices and depreciation of only 5 percent in a avoidance strategies, especially in de- discernible short period (say, a veloping countries, whereby specula- week or a month), he or she will tive financial transactions would be not refrain from speculating if a tax declared to represent the financial of 0.1 or 0.5 percent is levied. As corollary of real economic transac- 5 the foreign-exchange crises of the tions. This is why Tobin accepts the 1990s in Latin America, in South- tax to apply to all financial transac- East Asia, in transition countries tions without any discretion as a sec- and within the European Monetary ond best solution. System have demonstrated, the Tobin’s argumentation has a number repercussions of speculation can of weaknesses, which I have dis- cause exchange-rate changes that cussed more extensively elsewhere go well beyond the 5 percent (Spahn 1995, in particular Chapter 5 mark.7 „The four dilemmas of the Tobin tax“). It is for these and other considera- The main problems are the following: tions8 that I have come to the conclu- » International financial markets have remarkably changed since 6 Even the term „speculation“ is vague and of- the end of the Bretton-Woods sys- ten abused ideologically. I use the term in a technical, intentionally value-free, connotation. Some reflections on “speculation” are found in 4 Appendix 3. In fact the French parliament took provisions to exonerate such transactions. However it ig- 7 Some examples of currency crises with a nores or underestimates (in spite of earlier dramatic impact on the exchange rate can be negative experiences with capital controls) the found in Appendix 3. administrative intricacies of such exemptions 8 and the potential for evasion strategies. These „other considerations“ include doubts 5 that a reduction of liquidity would contribute to Especially in developing and emerging stabilizing exchange rates. Theory and prac- economies the distinction between financial tice commend that less liquid markets are ex- transactions of dissimilar kinds is extremely posed to higher and more abrupt price volatility difficult to make. Insistence on such a distinc- than more liquid markets. I shall come back to tion would only encourage corruption, as offi- this point later in this Chapter when discussing cial documentation is often cheap to obtain. systemic aspects. Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 3 sion that a tax on foreign exchange Table 2: transactions, as originally conceived Development of transaction volumes by Tobin, is an inappropriate instru- on international foreign exchange markets ment for mitigating exchange-rate volatility. The higher the tax rate, the Daily average in In- more aggravating the repercussions Year bill. US Dollars crease on the world financial system will be- (April) at constant $-rates in (of April 2001) come; the smaller the rate, the less percent suitable it will be to deter speculation. 1989 570 – However this does not imply the con- 1992 750 31.6 clusion that the objective of stabilizing exchange rates cannot be achieved 1995 990 32.0 through a tax on foreign exchange 1998 1,400 41.4 transactions.
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