The Tobin tax – an unnecessary debate (10 September 2001)

The “Tobin tax” (a tax on foreign-exchange transactions) is currently experiencing a comeback, being thought to be an instrument to curb the alleged overshooting of exchange-rate movements. While no policymakers explicitly support the Tobin tax, comments by Lionel Jospin and Gerhard Schröder show that there is a risk that the debate assumes a momentum of its own. At their most recent bilateral summit Germany and France decided to establish an expert group to examine possible ways to keep the international financial markets better under control and to analyse the Tobin tax. Now what can be said about the Tobin tax?

The first problem is that its proponents do not say clearly what they want to accomplish with the tax. Sometimes their arguments get mixed up, too. Basically, there are two politically relevant purposes: First, the Tobin tax is to become a new source of financing to help step up development aid for the poorer countries. And second, the Tobin tax is to be used as an instrument to stabilise the financial markets.

The first argument – introducing the Tobin tax to increase development aid – is questionable from both a political and an economic point of view: If politicians want to step up development aid, they should earmark budgetary funds for this purpose and make all taxpayers contribute to the financing, not only certain groups (in this case the actors in the foreign-exchange market). Moreover, expectations of high tax revenues are misleading. Depending on the tax rate (proposals range from 0.05% (Uwe Jens, SPD), over 0.25% (Dornbusch) and 0.5% (Tobin 1994) to 1% (Tobin 1978)), estimated revenues from a tax on foreign-exchange transactions can add up to amounts running into the hundreds of billions. But since the tax aims to reduce the foreign-exchange transactions, the tax base is going to shrink and – with the tax rate remaining unchanged – tax revenues are going to decline over time (assuming the tax has an effect).

The second argument – the Tobin tax contributes to a stabilisation of the financial markets – does not make economic sense either. In fact, the opposite is true: arbitrage transactions stabilise exchange rates. As arbitrage transactions vanish, the markets’ liquidity will decline (since spreads are small in foreign-exchange trade, a very small tax rate can already have this effect). But volatility tends to be higher in a tight market because small transactions are sufficient to seriously upset the market. For example, foreign-exchange fluctuations were bigger during the 1970s and 1980s than today.

Moreover, if large-scale exchange-rate shifts are to be expected, speculation for or against a currency will become so profitable that the tax will, in fact, lose its bite. Sudden exchange-rate depreciations of up to 40%, such as they occurred for example in the financial crises in Asia in the 1990s, could not have been avoided by a Tobin tax. Moreover, exchange-rate slides do not trigger crises, but are symptoms of bad economic policy.

Throwing obstacles in the way of arbitrage transactions will have a negative effect on the efficiency with which the exchange rates reflect new information and market assumptions about economic developments and monetary and fiscal policies. The Tobin tax would make all foreign-exchange transactions more expensive, regardless whether they are based on real-economy transactions (i.e. imports and exports) or stem from financial motives (i.e. portfolio investment). This would weigh on companies’ foreign-trade activities and interfere with the idea of trade liberalisation. Moreover, it runs counter to the legal provisions on the free movement of goods and capital within the EU.

The argument that there is excess liquidity in the markets which would be reduced by the Tobin tax is wrong, too. The large trade volumes (daily turnover: about USD 1 trillion) reflect the specific conditions of foreign-e xchange trading: not only the underlying transaction, but all intermediate transactions are included in the statistics. One customer order can trigger more than six transactions on the interbank market.

Finally, the Tobin tax is not feasible. It is unrealistic that it will be simultaneously levied all over the world. Investors will transfer their business to countries that do not levy this tax, and financial instruments (derivatives) will be used to circumvent it.

Any unilateral attempt by a country or a group of countries to introduce the tax would not only be ineffective, but would also lead to international investors losing confidence in the respective economy or economies. As a consequence, interest rates would increase and the currency/currencies would come under downward pressure.

What is much more important than the debate about the Tobin tax is the question how a sensible regulatory framework for the global financial markets should be achieved. A number of private and official initiatives have been started on this subject in the framework of the deliberations on crisis prevention. These efforts should receive the attention that is currently paid to a superfluous debate.

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For in-depth analysis, see the Deutsche Bank Research:

The Tobin tax – an unnecessary debate.

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