On the Feasibility of a Tax on Foreign Exchange Transactions REPORT To the Federal Ministry for Economic Cooperation and Development, Bonn by Paul Bernd Spahn Goethe-Universität, Frankfurt [email protected] Frankfurt am Main February 2002 On the Feasibility of a Tax on Foreign Exchange Transactions SUMMARY II CHAPTER 1: MOTIVATION 1 CHAPTER 2: INSTRUMENTATION 14 CHAPTER 3: ORGANIZATION 29 CHAPTER 4: IMPLEMENTATION 47 CHAPTER 5: REACTION 63 APPENDICES AND REFERENCES 70 INTERVIEW PARTNERS 71 FORMULAE 74 SPECULATION AND CRISES 76 SPREADS AND VOLATILITY 80 ABBREVIATIONS 83 REFERENCES 84 On the feasibility of a tax on foreign exchange transactions Summary A tax on foreign exchange transactions is expected to realize different objectives: 1. The stabilization of exchange rates, 2. the exploitation of new revenue sources 3. the redistribution of resources, in particular be- tween financial and producing sectors, and between nations (in particular between the North and the South) , and 4. aspects directed toward transforming the world economic order, in particular with the aim of controlling the process of globalization. Systemic change is not pursued in this report. On the contrary: The proposals of a tax on foreign exchange transactions are contingent on avoiding a negative sys- temic impact. Aspects relating to distributional issues are discussed in an ancillary manner only. They fall ulti- mately in the realm of politics. The present study focuses mainly on the feasibility of a tax on foreign exchange transactions with emphasis on the objectives of exchange-rate stabilization and fiscal revenue. The scope for political decisions on a tax on foreign exchange transactions is constrained by the fact that the tax has to be introduced and accounted for by existing political decision bodies, in particular national and su- pranational parliaments. The tax will therefore have to be unilateral and partial, not multilateral and universal. Moreover, tax revenue will fall to the jurisdiction that is accountable for legislating the tax, not to international organizations. Multilateral international bodies may how- ever be given some or all of the revenue in a second step—via budgetary grants. The analysis has brought to the fore the following re- sults: Political restrictions Switzerland. 1. As to „politically feasible“ 7.The exchange-rate instruments to curb foreign normalization duty should be exchange speculation, the applied unilaterally, but only by discussion focuses on non- transition, developing and remunerated reserve requirements emerging economies, and by those of foreign currency transactions industrialized countries that aim at and/or deposits. There is also a pegging their currency to one of the proposal by Zee to use an larger currency areas (or a basket asymmetrical cross-border capital of currencies). tax on imports of foreign capital 8. The combination of two taxes (albeit not on exports). Both in the form of a Tobin-cum-Circuit- instruments are interesting as parts Breaker Tax possesses significant of an arsenal devoted to coping allocative and distributive with currency speculation. advantages over the prevailing 2. In particular non-remunerated orthodox policies to stabilize reserve requirements are likely to exchange rates. form part of the future global Market structure and economic financial architecture. restrictions 3.The proposal of an 9. The analysis of the structure of asymmetrical tax on cross-border foreign exchange markets reveals capital flows appears to be laden further elements that restrict the with severe and complex scope for a Tobin tax. Such administrative problems however. restrictions are mainly economical This renders its realization highly and relate to issues such as the unlikely. level of taxation (tax rate, tax base), 4.Both instruments are and to the distribution of tax essentially distinct from a tax on revenue. foreign exchange transactions as Tax rate examined in this report. 10. If the purpose of the tax is to Concepts be borne by traders/banks, the bid- 5. To reconcile the objectives of ask spread will limit the margin for exchange-rate stabilization and re- the rate. With the bid/ask being venue generation, a unilateral and roughly one basis point for more „politically feasible“ Tobin tax liquid markets, the tax rate should (PFTT) on foreign exchange not exceed half or one basis point. transactions with a small rate, 11. If one assumes the tax to be combined with a high-rate shifted, it entails that it be borne surcharge on externalities resulting substantially by non-banks. from speculation, the „Exchange However non-banks represent only Rate Normalization Duty“ appears 13.3 percent of total turnover. It to be most promising. Both taxes implies a leverage effect that could would be technically intertwined. multiply the tax burden on non- 6. The Tobin tax proper can be financial agents by a factor of up to implemented unilaterally by 7.5. member states of the OECD, 12. If the bid-ask is accepted to individually or (preferably) as a limit the scope of taxation, the uni- group. It could also be form tax rate of a PFTT should then implemented by the European be derived from the conditions Union in cooperation with prevailing in the more liquid markets. This confers a relative Operations advantage to less liquid markets 17. There is a number of positive where the spread is higher. But this factors that prevent foreign should be conceded because it exchange transactions from favors the lesser industrialized migrating off shore into tax havens. countries. The tax rate should then These are the concentration of fall in the range of one half to one business onto one main financial basis point. The financial sector center as a „natural monopoly“ then likely bears part of the tax. within the time zone, complexities 13. At this level of taxation, there relating to foreign exchange is no need to relieve exporters, transactions and their derivatives, importers or direct investors from as well as significant network tax. externalities. However this is Tax base contingent on a tax policy that respects the specific features of 14. The tax base could consist of liquidity trading and recognizes the all spot transactions, and outright effective margins of trading as a forwards and swaps up to one constraint on tax rates. month. Options and other financial derivatives will not attract the tax Implementation directly, but they are taxed 18. The problems relating to the indirectly through the spot and implementation of a PFTT are forward transactions they trigger. rather complex. First of all, there Partitioning tax revenue must be clear principles to guide tax policy. They concern the 15. The PFTT is inappropriate as a definition of the tax base and the national revenue raising taxpayer. A reasonable approach instrument. This results from the will be to base the tax on a “market fact that foreign exchange principle”, whereby all traders transactions are carried out by accredited in European financial time zone. Moreover there is a centers, centrally operating clear-cut trend toward centralizing automated broker systems and these transactions at one center clearing/settlement systems will be within the zone. This implies the taxable. The same is true for tax to be implemented for the EU as foreign exchange trading by non- a whole, including of course its banks (such as Volkswagen or main trading place, London, but Daimler-Chrysler). also Switzerland as a potential rival within the zone, but outside the EU. 19. Generally speaking there are two options to define tax liability: at 16. Tax revenue is collected by the trading desks, or at the time of central banks, but it falls to the re- settlement. Both procedures gion as a whole, not to national appear to be feasible, although authorities. It could be they both have advantages and redistributed to national disadvantages. governments via formula-based transfers, but it should preferably 20. If the tax is levied at the go into a European Fund for trading desks, there may be a Economic Development to be cumbersome reporting necessity, managed at the level of the EU. It is which is inappropriate in view of of course conceivable the revenue the electronic platforms that to be used for other „global public characterize the market. This could goods“ as well. be avoided by an automated, centralized tax collection at the two options to implement such a stage of clearing or settlement. The tax, one starting form the trading latter still poses problems as the desk, the other operating at the available information is not passed level of settlement. Both appear to on to the settlement stage now. be promising. Moreover, only spot transactions 25. The knotty problems are not at would be recognizable when all technical. They are related to settling claims. political will, to international 21.However the further cooperation, and to legal concentration and automatization enforcement. of foreign exchange trading, in Reactions particular the introduction of a 26. The introduction of a PFTT will continuous link gross settlement entail a number of very different system will significantly improve reactions among actors on foreign the conditions for levying the tax at exchange markets. It is to be settlement stage. This is why I expected generally that trading prefer this latter approach. It volumes will decline, and that the requires a different principle of bid-ask spread will widen. This taxation though, which I have raises the question of who will bear dubbed the “access principle”. It the burden of the tax. This question defined tax liability from the access is largely open and controversial. to official national gross settlement systems, with contractual 27. Most affected by the tax are „backward chaining“ by which those engaging in covered interest operations prior to settlement are rate arbitraging. However, given the included. extremely thin margins of this business, it is likely that the higher 22.It seems obvious that this risk will be largely shifted forward procedure will also require some though higher premia.