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 repeatedly 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 foreign 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]frankfurt.de 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 In fact the French parliament took provisions Appendix 3. 7 to exonerate such transactions. However it ig- 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. Such a tax must only be designed in a different way as pro- 2001 1,210 –13.6 posed by Tobin. Theoretical considerations by Tornell (1988, 1990) have encouraged me to ponder on ways to Purely arithmetically, the multiplication use taxation as a mean to achieve ex- of such transaction volumes with even change rate stabilization. It led me to smallest tax rates produces significant a “two-tier” tax, whereby a proper amounts of revenue. For instance, Tobin tax (albeit with a very small tax with roughly 250 business days per rate) is combined with an exchange- year, a tax base of $300 trillion could rate normalization duty (ERND). The be calculated for 2001, and a tax rate former is apposite primarily as an in- of only 0.1 percent would then pro- come-generating device while the lat- duce a yearly revenue of about $300 ter takes up the function of stabilizing billion.11. exchange rates. The proposal is fur- I consider such calculations dubious ther explained in Chapter 2. for several reasons. » First they do not account for the » The exploitation of new revenue structure of the market and its sources. Fiscal aspects are not in the possible alterations that could re- forefront of Tobin’s proposal.9 How- sult from introducing the tax. ever he also realizes that a tax on for- » Furthermore, total transaction vol- eign exchange transactions could umes contain distinctive financial raise substantial revenue. This results instruments: spot transactions and from the enormous amounts of foreign outright forwards, foreign ex- exchange transactions that have change swaps, options and fu- evolved over the last decades.

According to a tri-annual survey on 11 the developments of foreign exchange The French parliament, in its legislation of markets published by the Bank for In- last year, proceeded in a similar fashion. It ternational Settlement (BIS) in Basel, based its estimate on the daily transaction volume of its financial center Paris (56.5 bill. eu- the following transaction volumes are ros), accounting for a yearly deduction of 10 obtained as depicted in Table 2 : 1,017.75 bill. euros (or 4.1 bill. per day), which corresponds to transactions of the trade bal- ance and direct foreign investment that are ex- 9 onerated by law, and thus calculated a tax „Raising revenue has never been my main base of about 50 bill. euros per day. At the motivation.“ (Tobin 1996, p. xvi). maximum rate provided by the law of 0.1 per- 10 See BIS, Quarterly Review, December cent, this was expected to generate revenue of 2001, p. 39. 50 million euros per day (or 12.5 bill. per year).

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 4 tures. It is unclear in which way markets and the world economy.13 such different instruments would 2. Legal avoidance by using non- bear on such revenue estimates. taxable money substitutes and fi- » Moreover the number and struc- nancial innovations. This includes ture of participants in foreign ex- a possible retreat into a single change markets has changed world currency for handling liquid- dramatically in recent years. This ity trading (the US dollar), with cor- has had a lasting impact on the responding differential compensa- tax base.12 These developments tions via financial derivatives. will be discussed further in Chap- 3. An increase in the effective- ter 3. ness of currency trading. This is » In addition, the development of achieved through net clearing sys- foreign exchange markets is char- tems, the institutional consolida- acterized by dramatic technologi- tion of the financial sector, the cal changes, for instance the in- outsourcing of financial transac- troduction and further develop- tions into non-financial institutions ment of automated brokerage sys- etc. tems, net clearing and settlement 4. The legal and illegal relocation (e.g., „front-loaded“ and „continu- of financial operations into tax ha- ous settlement“). Such develop- vens. ments had a significant impact on the structure of markets and they Further considerations as to possible are likely to prevail in the future. evasive strategies under a tax on for- Their repercussion on the base of eign exchange transactions can be a tax on foreign exchange transac- found in Chapter 4. tions deserves further scrutiny Apart from the immediate goal of (see also Chapter 3). achieving fiscal revenue with a tax on » Finally—and not the least—a tax foreign exchange transactions, the tax on foreign exchange transactions is occasionally also considered to (as any other tax) will entail eva- work as a presumptive tax on capital sive strategies, which would nec- income. The argument is that under essarily curtail the tax base. These globalization it will become more and reactions are essentially of four more difficult to capture capital income types: from international investments with a national income tax. Such income fre- 1. The simple refraining from ex- quently escapes the income tax by ecuting a taxable transaction. This dislocating into tax havens whose entails an often-overlooked dead- governments are known to be unco- weight loss, which can also find its operative on source taxation. To the expression in higher economic extent that the Tobin tax would reduce risks. Such effects may possibly the net return on foreign capital in- correspond to the objectives of the vestments, a sort of presumptive in- critics of globalization, but it could come tax would become feasible, have fatal consequences for the whereby the transactions tax would stability of international financial generate some form of compensation, albeit crude.

12 For instance, the reduction in the volume of 13 transactions in 2001, compared to 1998, is This reaction also limits the scope for the chiefly explained by changes in the market rate of the Tobin tax. I shall come back to this structure (Galati 2001). in Chapter 3.

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 5 » Aspects of social justice and re- tied, not without reason, to the ac- distribution. cess to international exchange markets. The tax on currency transactions pos- sesses a politically strong symbolic Whenever distributional aspects are in force, which was hardly recognized by the game, the potential costs of redis- Tobin. This is why it is potentially ac- tribution have to be expressed in claimed both by the public and by poli- terms of efficiency losses. If the intro- ticians. Behind this symbolism there duction of a Tobin tax would result, for are rudimentary prejudices against instance, in heavy costs of foreign ex- “easily earned money” through finan- change trading and international capi- cial trading as opposed to “hard- tal markets, this would undoubtedly earned money” through labor. Adding have a negative impact on real eco- the notion of „speculation“ as a short- nomic variables such as investment, cut for „fraud“ plays this antagonism jobs, and incomes. The explanation of further up. such complex relationships is not easy however, and the inter-linkages are The political muscle of the Tobin tax is more difficult to convey that simplistic strengthened even more by the fact clichés of social justice, in particular that foreign exchange markets are as the financing of such redistribution (rightly so) considered to represent a programs is expected to be carried by colossal exclusive undertaking of n-i others (the “speculators”). Moreover dustrialized countries. The currencies the liberalization of international capi- of the OECD countries are involved in tal markets is often seen to deprive 89 percent of all transactions. The re- the Third World anyway. mainder falls almost exclusively to emerging economies (including the But even though there would be no currencies of Hong Kong and of Sin- negative impact on the world econ- gapore). The currencies of developing omy, the achievement of the goals of countries play practically no role. This international justice through a Tobin is why a tax on foreign exchange tax with corresponding transfers is not transactions can be seen to burden necessarily assured: mainly the richer industrialized na- » On the one hand it is possible— tions. Its revenue could be reserved and even probable—that the fi- for foreign aid to developing countries nancial industry would shift the tax implying a more equitable distribution on currency transactions onto pro- of opportunities within a globalizing ducers and consumers, and not world economy. 14 carry it itself (see Chapter 5). Thus the Tobin tax is hailed as a » On the other hand it is question- “righteous tax” in a double sense: able whether development policy » On the one hand as a compensa- is only a question of money and tion between the financial industry, can be accommodated merely by often depicted to be non-pro- financial transfers to the Third ductive (Karl Marx), and the pro- World. ducing sectors of the economy In particular this latter point would de- within industrialized countries; and serve a more comprehensive treat- » On the other hand as compensa- ment, which is of course not within the tion between developed and less- terms of reference for this study. developed economies (in short: Nevertheless it has to be mentioned between North and South), whereby the degree of economic 14 This would even be intended if the Tobin tax development is regarded to be were to serve as a presumptive income tax.

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 6 that development aid is often de- for a tax on currency transactions flected toward military spending, os- however: tentatious public consumption, non- Exchange rate volatility is not only a sustainable or unsuitable investment problem per se, it also affects the dis- projects, and even into private ac- tribution of wealth between industrial- counts of local oligarchies, which fails ized and developing economies, and it to realize the proper goals of devel- can thus thwart an aid policy that re- opment policies. lies essentially on budget policies. I consider structural reforms—within This point is often ignored because recipient and donor countries—to be development policy all too often looks basically more important for economic toward financial flows, and hardly ever development and an equitable and fair toward stocks and their changes in distribution of opportunities than the valuation.15 mere extension of international finan- Tobin himself has repeatedly argued cial transfers. In Third World countries that the reduction of exchange rate this includes, for instance, the recogni- volatility aims not only at the reorientation of human rights, reforms of edu- tion toward fundamental flows (such cation and health policies, of public as foreign trade, direct investments), administration (“good governance”), but also at the independence of the the struggle against corruption and the central banks from the vagaries of for- dismantlement of state monopoly eign exchange markets. In the ab- power and price controls that convey sence of such independence, a de- benefits to a small minority at the ex- valuation of its currency will compel pense of the broader population. In central banks to either offer high inter- donor countries the main problems est rates on overnight deposits (e.g., are, for instance, the collusion with lo- the strategy of the Swedish National cal potentates, the transfer of inap- Bank at the beginning of the 1990s), propriate technologies, or an ineffi- or to sacrifice foreign exchange re- cient policy of price subsidies, which serves in order to take out their own renders it difficult for developing coun- currencies from the market (or both). tries to overcome their dependency from primary production. To this com- This indicates one of the most impor- pounds the protection of import mar- tant asymmetries between industrial- kets—for instance for agricultural and ized and developing countries in the textile products—, which is inefficient era of globalization: While the leading and intricate from an equity point of industrialized economies were able to view. ascertain the independence of their central banks from exchange rate Structural reforms in these areas are volatility (obvious in the statutes of the often independent from financial as- ECB, but also apparent during phases pects. Conversely, specific financing of „benign neglect“ of American mone- models may contribute to preserve in- tary policy), the international consen- efficient and unfair arrangements. sus of economic actors and politicians Where this is the case, development expects from developing and emerg- aid would even jeopardize the realization of the very objectives of develop- 15 ment policy. This statement has to be taken cum grano salis however. Responsible politicians will rec- ognize both aspects and have acted accord- » Redistribution of national wealth. ingly—for instance through debt relief for the highly indebted poor countries (HIPC). Never- An important aspect of regional justice theless I have reasons to stress that point in a globalizing world has to be em- again—in view of more recent discussions with phasized in the context of a proposal politicians in the realm of development policy.

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 7 ing economies to defend, in the case ests, global warming, the loss of bio- of speculation, their currencies by sur- diversity), addressing global health rendering their arduously conquered problems (HIV/AIDS), malaria), re- foreign exchange reserves. Once search (to address basic questions of these reserve have been exhausted, global significance), and other goals of the countries are all too often pushed overarching interest (“global public into debt in foreign currencies.16 goods”). Whenever the central bank of a coun- The use of the attainable proceeds try has to surrender foreign exchange from a Tobin tax is ultimately a politi- that does not correspond to real capi- cal question that cannot be answered tal formation, this is tantamount to an in this study. However it is important international transfer of net wealth, to discuss who (i.e. which institutions, whose magnitude can easily dwarf the national or supranational) would col- flow of development aid. Arduously lect the Tobin tax eventually, because earned wealth can fade away within a this will also limit the possibilities of its short period of time due to currency use (see Chapter 3). speculation. A tax on foreign exchange transactions could not only protect the freedom to act of these » Systemic transformation. The tax countries’ central banks; it could also on currency transactions is finally generate some additional income in called for by political groupings whose the case of speculative attacks. aims are not always lucid, but are undoubtedly motivated by the desire to I think it is important to stress in par- transform “the system”. This is com- ticular the connectivity between the prehensible to the point of controlling potential loss of net wealth of develop- the process of globalization more ing countries, and budgeted develop- generally (its “humanization”). Why ment aid. Stable exchange rates thus should we forsake to impose onto in- become a precondition for effective ternational financial markets some development policies, which ought not rules as they have been adopted for be overlooked. long in the realm of national politics for As to aspects of distributional justice it banks, stock exchanges and other fi- must at last be emphasized that financial institutions? In this context, nancing development may not be the the Tobin tax can yet be only one only objective of a tax on foreign ex- element of a more comprehensive change transactions. In this context regulatory concept for global financial other global policy goals have been markets. It would be wrong to expect mentioned that could also be ad- the tax to solve all pending problems dressed by using the proceeds from a of the global financial architecture at Tobin tax. The tax yield could equally once. be spent for achieving general policy Systemic aspects of globalization are objectives (such as the war against indeed most prominent in international terrorism, the trafficking of humans, financial markets. It is there that na- arms, and drugs), ecological goals tional boundaries have come to play (such as the protection of tropical for- almost no role. Financial information is available to all market participants si- 16 multaneously, in real time, and ubiqui- The recent experiences of Argentina with its tously. Prices of financial products fixed-exchange rate regime—particularly vul- nerable to speculation (see Appendix 3)— have melted down under extreme render it obvious that the orthodoxy is pre- competition that leaves minute resid- pared to push a whole economy into insol- ual markups in the order of basis vency. points (hundredths of a percent). If

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 8 this model of global financial markets would lead to a more efficient alloca- is transposed onto the markets for tion of resources.17 goods and services, in particular the Others start from the intuitive—but labor market, it becomes understand- misleading—equation “commodity = able that an unfettered globalization is money = commodity” of Marx’s the- easily experienced as a threat, which ory—namely a one-to-one relationship would provoke political resistance. between transactions of goods and How these concerns of citizens are to money. They point to the fact that the be addressed will again be a task for volume of trading in international cur- politicians. Scientific analysis can offer rency markets has reached a multiple only limited assistance here. In par- of the value of foreign trade and for- ticular distributional issues are prone eign direct investment, and has lost to escape scientific analysis. It is any direct relationship with transac- however hardly contentious among tions of the real economy.18 economists that market forces are in a Such argumentation is misleading be- better position to unfold economic and cause it pays no heed to the nature of social welfare than administrative in- liquidity. According to my view a re- terventions by national and suprana- quest to limit the volume of financial tional governments. In this vein the transactions to the financial equivalent process of globalization is seen to be of activities in the real economy is tan- inescapable and irreversible—unless tamount to asking for a reduction of one is prepared to bear the immense oxygen in the air to the bare minimum cost burden that socialist countries necessary for life. had been willing to assume for decades. This can certainly not be ex- Liquidity is based on the fact that so- pected for all nations, which implies called “market makers” are willing to that countries opting out from global- set prices everywhere at any time for ization must fall behind economically typically large sums of foreign cur- in relative terms. rency, and to carry out conforming transactions. In a similar way as we According to my view, the yearning to would normally not think about the turn back the wheels of history by availability of oxygen in the air, liquid- means of a Tobin tax either comes ity thus creates freedom of action for from an ideologically-based position of exporters, importers, and direct inves- structural conservatism. It deems the financial industry, once again, to be 17 the “spearhead” of capitalism or glob- Also Tobin mentions that "vast resources of alization, which one hopes to domes- intelligence and enterprise are wasted in finan- ticate by a Tobin tax. Or it is (at best) cial speculation, essentially in playing zero- based on a misunderstanding of the sum games" (Tobin 1991, p. 18), which re- functioning of such markets, and of flects unawareness as to the character of liquidity trading. international liquidity trading in particu- 18 lar. As an example the Intergroup „Capital Tax, Fiscal Systems and Globalisation“ of the Euro- It is interesting to note that the volume pean Parliament notes that „as a means of of international financial transactions comparison, the total yearly exchange of has been regarded to be excessive by goods and services is evaluated at 4,500 billion dollars, equivalent to less than a week on authors of very different political the currency market. Today, most of the trans- trademark. For instance Summers and actions on the currency market have no link Summers (1990), p. 881) expect a tax with exchange of goods and services or in- on foreign exchange transactions to vestment and are purely speculative“ (Declara- eliminate „wasteful trading” and „ex- tion in preparation of the International Confer- ence „Financing for Development“ in Monter- cessive financial engineering“, which rey; emphasis added).

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 9 tors. logical tensions will be discharged in an earthquake. The introduction of a Liquidity does not only trim down price Tobin tax could even provoke a se- and settlement risks, and it reduces vere liquidity shock at a global scale if the costs of hedging; it also prevents it is effected thoughtlessly and disre- destabilizing insolvencies. gards the structure of markets.20 This implies however that the market Some prominent authors have argued maker is able to close his/her open however that a financial transactions position in a foreign currency immedi- tax with a very small rate would affect ately in order to eliminate risks and to liquidity trading only negligibly but remain solvent. Open foreign ex- eliminate a behavior that is character- change positions are thus handed on ized as destabilizing “noise trading” like “hot potatoes” until they finally (Summers and Summers 1990). This reach a market participant who is will- behavior is described in a new brand ing to hold a corresponding counter- of the financial literature “that ques- position. In this way one transaction tions more generally the efficiency of initiated in the real economy can trig- 21 financial markets”. Noise traders act, ger a whole chain of subsequent fi- unlike informed “rational” traders, on nancial transactions. The demand to the basis of misinformation such as limit financial transactions to the “nec- technical investment analyses (chart- essary scale” overlooks that this scale ing techniques), or rumors. Their be- cannot be based on the value of eco- havior can drive prices off their fun- nomic transactions. damental equilibrium value, which It is unquestionable that a Tobin tax renders markets more risky and vola- would reduce the volume of foreign tile (Shliefer and Summers 1990). In- exchange transactions. The disadvan- formed traders cannot counter these tage is however that the tax cannot destabilizing tendencies (DeLong, distinguish between liquidity trading Shliefer, Summers, and Waldmann and speculation. It would particularly 1988, Summers and Summers 1989). hit the stabilizing liquidity trade be- This is because arbitrageurs usually tween wholesalers. This would lead to operate without reference to funda- “thinner” markets with less liquidity. mental data by optimizing their deci- Stabilizing arbitrageurs would with- sions exclusively in view of a given draw from currency trading and only price, and by realizing only a local op- resume their activities if the actual ex- timum. This actual price can deviate change rate deviates from its “intrin- significantly from its fundamental sic” value (respectively, its value as- value and thus create “speculative sumed to be realistic) by more than bubbles”. To the extent that the Tobin the tax rate.19 This would increase the tax could reduce such noise trading it volatility of exchange rates because would contribute to stabilizing foreign the price-discovery process will be in- terrupted and prices can no longer re- 20 flect all information available on the This argues in favor of a low tax rate when introducing the tax. I even imagine starting with market. Prices will then adjust abruptly an algorithm for calculating the tax that con- whenever the deviation from a pre- tains a zero tax rate initially. This would not sumed equilibrium rate has become produce any tax revenue but allow to identify too great—as gradually accruing geo- the potential tax base on a recurrent basis and to monitor its reactions to a modest increase of the rate in a heuristic fashion. 19 21 "With the tax in place, arbitrage investors This literature "has developed the perspec- would wait for larger price discrepancies be- tive that the financial markets may not be as fore entering the market" (Kiefer (1990), p. efficient as previously thought" (Kiefer (1990), 891). p. 889).

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 10 exchange market even at very low avoid a negative impact of a Tobin tax rates. on the functioning of world financial markets. This thesis is important because it would resolve the apparent contradic- » Summary. Taxes on currency tion between exchange rate stabiliza- transactions pursue very different ob- tion and revenue raising at low tax jectives. The more important ones re- rates. I am however not convinced late to stabilizing exchange rates, pro- that the thesis is necessarily correct. ducing fiscal revenue, and redistribut- Liquidity traders would usually not use ing resources between the financial chart techniques in making their deci- and producing industries, and be- sions, although they are of course not tween countries (in particular between immune against exploiting rumors. North and South). The tax is also ex- Chartists are mainly found among the pected to aim at systemic changes customers of foreign exchange traders that are directed against the process outside liquidity trading (for instance of globalization. institutional investors such as invest- Systemic changes are not considered ment funds or hedge funds). Their po- in this report. On the contrary: the tentially speculative actions are prone proposals for a tax on foreign ex- to affect the exchange rate more change transactions are subject to heavily than the more neutral behavior avoiding systemic effects as much as of arbitrageurs. But the presence of possible. the latter group is much more pro- nounced than the former. It means Distributional objectives are also not that the tax would still affect liquidity pursued in this study because they operations more heavily than noise remain the privilege of politicians. trading. The centerpiece of the study on the As to the exploitation of rumors and its feasibility of a tax on foreign exchange effect on the exchange rate, it is ques- transactions is formed by the two ob- tionable whether a Tobin tax could jectives stabilization of exchange rates counter the destabilizing effects that and fiscal revenues. this may trigger. In this respect it is true what has been said before: the tax is ineffective whenever the expected variation of the exchange rate is higher than the tax rate even by a small amount. The worst would be if the tax would reduce noise trading only partially or not at all, but lessen or even eliminate stabilizing liquidity operations. This must lead to greater volatility in world financial markets.22 Systemic objectives will not be considered in this study. On the contrary I believe that developments in world financial markets have to be appraised positively. It is all the more important to control systemic effects in order to

22 Moreover the entailing contraction of the tax base is hardly in the interest of those who expect revenue from the tax.

Paul Bernd Spahn ® [email protected] On the feasibility of a tax on foreign exchange transactions ® Chapter 1 ® Page 11