The Tobin tax

The Tobin tax : a periodically fashionable idea, « miracle cure» that often unleashes passions mostly for ideological reasons than economic. It is necessary to review its relevance by assessing it objectively, and understanding what can make it, in some ways, desirable, but also its shortcomings.

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James Tobin, Nobel Prize in Economics in 1981 for his work on the financial markets, advanced the idea of a tax on currency transactions (exchange of currencies on the foreign exchange market) in 1972; he subsequently developed the idea in 1978. At that time, and in the spirit of its inventor, the establishment of such a tax was intended to give more autonomy to national monetary policies. In fact, an expansionary monetary policy aimed at boosting the activity - which may use for example the instrument to lower the central bank interest rate - which normally result in capital withdrawal, leading to the currency depreciation. In principle, the tax should deter these capital outflows, giving flexibility for the monetary policy. But today this original goal is no longer the argument of the Tobin tax proponents. Being set aside for a while, it is now to the fore in the context of financial and foreign exchange market instability, and presented as a means to limit their "irrational exuberance" and excessive volatility.

To its defenders, it is above all a reform designed to regulate the international financial system out of control. it is true that there are flaws in this system. The process of liberalization and disintermediation, the deregulation, the abundance of savings, advances in telecommunications technology, and finally measures to promote individual and collective shareholding have contributed to increase the volume of transactions. Meanwhile, the volatility remains, many investments are short-term, speculation has reached alarming proportions, and the financial sector tend to become autonomous. Some destabilizing capital flows trigger crises with negative consequences in the "real" economy. recently, we recall the crises in Latin American, Asia and Russia, LTCM and e-crash... According to its advocates, the tax, by increasing transaction costs, would discourage short-term volatile capital flows and thus contribute to reduce the monetary and financial system instability. Reducing the speculators flexibility should stabilize international finance.

According to its advocates, the tax, by increasing transaction costs, would discourage short-term volatile capital flows and thus contribute to reduce the monetary and financial system instability.
Pierre Chaigneau

The tax would also be the first international tax, which is expected to better fund international structures such as the IMF. Resources could be allocated to the creation of a stabilization fund in charge of playing the role international lender of last resort and to help central banks facing a financial or foreign exchange crisis. A global economy requires that the national framework is exceeded, particularly in the areas of control, regulation (even if only to avoid systemic risk), or the collection of taxes (to avoid the adverse effects of fiscal dumping, and to finance global public goods). A tax introduction in the world is moving in this direction.

Despite these advantages, the Tobin tax has definite disadvantages.

First, an implementation at the international level looming complicated: it is difficult for individual countries to reach a consensus on the precise modalities of its implementation. Even more problematic, all states will not want to apply that such taxation. It is impossible to limit it to a few countries that would agree to implement it. It would marginalize their financial place and promote the development of offshore financial centres. In fact, capital will move from regulated and controlled markets to benefit from the opportunities they receive in offshore countries. the lack of transparency and prudential rules, and the fragile supervision of the banking and financial system are the characteristics of offshore centres, which are a factor of weakness and instability. It is also the duty to intervene to eliminate them as quickly as possible.

Moreover, small countries not part of a monetary union, that would introduce the Tobin tax would be marginalized on the international capital markets. because opening a position would be more costly. Therefore, investors would rather focus their operations on large monetary sets, such as the Euro or the dollar zone. The other countries would endure low liquidity in their financial system, securities prices mismatches, many distortions, and ultimately an unattractive and inefficient financial system.

Also, warned operators could easily circumvent such a tax by multiplying the number of transactions in the derivatives by developing financial innovation. The Tobin tax would help in these circumstances to make the financial system more complex and therefore more fragile. Finally, to offset the rise in transaction costs, operators would be encouraged either to raise the general level of risk in their portfolio, so that the extent of capital gains expected exceeds the level of transaction costs, or not carrying out the necessary transactions for market stability. So we have identified four adverse effects, opposed to the objectives of the Tobin tax : its introduction is likely to weaken and destabilize the financial system. The negative effects do not end there.

The Tobin tax would reduce the financial markets liquidity, as well as their informational efficiency. It would reintroduce financial anomalies eliminated by lower transaction costs, and make more costly hedging transactions aimed to stabilize the markets.
Pierre Chaigneau

It first reduces the liquidity of stock markets and currency markets, which thus become less efficient. Then, if it is useful to discourage short-term destabilizing speculation, it also penalizes some short-term transactions that would be desirable, impeding arbitrage trading or hedging, for example - as a transaction tax affects more heavily the positions in the short-term. But do not confuse two short-term operations such as blind speculation and stabilizing arbitrage. The latter is essential for securities prices adjustments : in order for them to match the fundamental values in the case of shares, and so that their risk premium adjusted return matches the "global " return in the case of bonds for example. short-term capital flows are beneficial and even essential for the proper functioning of the international financial system. Hedging, which also often takes place in the short-term is essential to enable companies who want to transfer risk to another agent. It promotes the expansion of international trade, enabling them to hedge against foreign exchange risk in particular.

Furthermore, it is not certain that the Tobin tax reduces the daily volatility in financial markets and foreign exchange markets. On the contrary, by reducing the market liquidity and arbitrages made (in both quantity and quality), it may increase it. It may also be ineffective against the large speculative movements and long time price deviations around the fair value. The dilemma is in fact that if it is applied at a low rate (0.01% for example), it is not a deterrent against market movements that cause major imbalances and crises. And if it is applied at a high rate (1% for example), it generates distortions that considerably reduces the efficiency of financial markets and disrupting the optimal allocation of capital and international trade. Finally, it should be noted that one cannot have everything : either the tax in fact brings in a lot of resources, indicating that it does not discourage short-term transactions (so that it is ineffective), or it brings in few value, and that means it deters most operations, including those that are desirable (so that it greatly reduces the financial system efficiency).

Tobin himself admitted : " The more important the tax will be, the more it will have missed its target, because that will mean that short-term speculative movements will not be stopped.

Despite the advantages that would make a low tax levied on capital flow desirable in some respects, the Tobin tax would not achieve its objectives. And difficulties in its implementation seem prohibitive.

What is the experts opinion ? To reduce financial instability, a consensus is emerging on reforms aimed at:

- Ensure the soundness of local banking and financial structures before implementing free capital flow within a country;

- Fight effectively against offshore centres;

- Promote transparency in order to reduce information asymmetries;

- Encourage people to establish internal systems for controlling the their positions risk;

- Internalize the costs of a financial crisis by addressing the moral hazard and empowering the owners of capital

- Develop a better international coordination of national policies and give real means of action in international organizations like the IMF in order to effectively manage crises.

All this mobilizes fewer activists crowds. It is a good indicator of quality.

EE , Pierre Chaigneau , July 2011

Article also available in : English EN | français FR

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