Taxing Excessive Currency Speculation
To Prevent Social Crisis and Finance Global Challenges
A CIDSE-Caritas Internationalis-Justice and Peace Europe
Background Paper - January 1999

Part Two

1. The simple Tobin CTT proposal

A Tobin-type tax proposal calls for a tax that would be payable every time a currency is converted. The original proposal by James Tobin, launched in 1972, calls for a internationally uniform tax (set at 1% in the original proposal) on all spot conversions of one currency into another, proportional to the size of the transaction. Tobin's proposal has a large intuitive appeal, since it kills two birds with one stone:

• it would discourage speculation by making currency trading more costly, i.e. by "throwing some sand in the efficient wheels of international finance". Because the tax rate is insensitive to the maturity of the transactions, the real tax burden would be higher the shorter the time horizon of the operation, so short-term speculative behaviour would be penalised, which would supposedly lead to greater exchange rate stability.



• at the same time, with annual estimates of the tax revenue ranging from a few tens of billion to a few hundreds of billion US$ (depending on assumptions over the tax base, tax rate and types of financial instruments taxed), this globally-raised revenue, largely out of the control of sovereign states, would create a truly global revenue base to be (partly) used to meet global challenges, such as maintaining a stable international financial system or worldwide poverty alleviation. This comes on top of not having to spend scarce resources of IMF-lending to restore financial stability after the crisis. Moreover, to the extent that part of the revenue could be used nationally to solve national problems, this increases the attractiveness of it to budget-constrained (also industrialised) countries.

The appeal of the proposal is even greater since it could be used to correct other existing distortions, such as:

• uneven distribution in global wealth and wealth creation. Global wealth today is increasing by about US$ 700 billion each year, but only a small part of it goes to the poorest. Moreover, (speculative) investment in financial assets accounts for a considerable part of this wealth creation.



• the current distorted tax structure, both internationally and nationally. International financial transactions go largely untaxed. Also at the national level, there is a big disparity between observed tax burdens on labour versus those on capital. In general, and especially from an ethical point of view, there is no good reason why financial transactions - as opposed to all other transactions - should not be taxed. Here, a Tobin-type tax could act as a surrogate for a more general capital income tax.

Despite this intuitive appeal, the proposal was never seriously considered in the major international decision-making fora; not even when it re-emerged in periods of financial crises. Apart from the political aversion against tax measures that might in future lead to threatening national tax sovereignty by levying some sort of 'international taxes' (even if it is basically a national tax that is partly redistributed internationally), which is clearly very strong in some major countries, the proposal is highly criticised by financial economists due to a number of technical problems. Box 2 gives an overview of these problems.

Over the years, the original proposal has been revised, taking into account some of the critiques. A number of the more technical counterarguments can be dismissed (1). An important point regarding this issue of practicability is that (usually modest) financial transaction taxes (and more generally called 'securities transaction taxes', or STT), usually as taxes on buying and selling of shares and bonds, are already levied in quite a few countries. There are examples where these STT work effectively (2). Even in the US, (however cautious) supporting cases of (national) STT have been made by leading academics, among them people who are currently having high-level political functions, such as Joseph Stiglitz (now World Bank chief economist) and Lawrence Summers (now under-secretary of the US Treasury). A number of related alternatives, such as compulsory non-interest-bearing deposits with central banks (related to the size of foreign exchange purchases) or capital charges on net foreign exchange positions, have also been launched, without much success.

However, in addition to remaining obstacles of a political nature, even the revised version, as well as most alternatives, still share a remaining basic flaw, which is linked to the determination of the exact magnitude of the tax rate: if imposed at a high rate, the tax would seriously impair also the more desirable operations of financial markets or would induce massive evasion efforts. Yet, if the tax were to be imposed at a low rate, it would not deter (currency) speculators who expect significant short-term price changes, and, ultimately, would not prevent undesirable financial transaction behaviour from taking place: grains of sand in the wheels is not enough where boulders are required (Davidson [1997]). If this flaw is not taken into account, the proposal will be countered by the financial establishment, based on (justified) technical arguments.

2. One realistic way out: a two-tier CTT à la Spahn

Fortunately, there is a solution to the basic flaw in the original Tobin tax just mentioned. A commonly known solution to this type of problem is to match targets and instruments by installing a separate instrument for each goal to be attained. Applied in this context, it would ask for an instrument that, on the one hand, creates a fairly high revenue because of the sheer magnitude of the tax base involved, without inducing widespread evasive behaviour and without creating additional distortions, and, on the other hand, an instrument that is activated only in very specific circumstances, i.e. when large national social costs and systemic effects are incurred.

A CTT proposal of this nature is being suggested by Bernd Spahn [1996] (3), i.e. a two-tier Tobin tax, levied as a national tax but introduced through an international agreement, with a minimal-rate transaction tax on all transactions (the 'basic tax'), and a high tax rate (an exchange 'surcharge') that, as an anti-speculation device, would be triggered only during periods of exchange rate turbulence and on the basis of well-established quantitative criteria.

• The minimal nominal charge of one or two basis points (i.e. 0.01 or 0.02%) of the basic tax would not create a significant distortion, would not create massive evasion efforts and, as such, would establish a considerable revenue base. In addition to the revenue aspect, such a tax would act as a monitoring device, facilitating the follow-up of movements in the market.




• The surcharge would aim to tax, at a prohibitively high rate, the occurrence of 'excessive' exchange rate volatility. Spahn suggests a mechanism that is very similar to the (old) European Monetary System's mechanism for achieving exchange rate stability, with the surcharge being switched on whenever the trading price for a currency passes a predetermined threshold. This threshold would be determined by a changing target rate (a 'crawling peg', determined by a moving average) plus a safety margin (defined as a percentage of the target rate, creating a band). When the currency fluctuates within the band, no surcharge is levied - only large-scale speculative behaviour would induce the actual exchange rate to break out of the band and trigger the tax mechanism. As such, the mechanism rather discourages speculative behaviour because of the tax threat; ideally, the revenue from the surcharge is zero. Unlike the EMS however, exchange rates would be kept within the target range through taxation rather than through central bank intervention (which typically uses interest rate increases or depletion of international reserves).

The essence of the surcharge mechanism can be easily clarified when illustrated graphically, as below. The exchange rate parity changes along time as a result of actual exchange rate changes, using a moving average technique. Around the parity, a lower and upper bound is determined in proportion to the target rate, creating a band area. As long as the actual exchange rate moves within the band, only a small tax is levied. Only when the actual exchange rate jumps out of the band (as a result of a large exchange rate change, possibly as a result of a speculative attack), is the difference between the actual and the bound (as illustrated by the shaded area in the graph) taxed at a high proportional rate.

The international financial establishment, as well as a number of political decision-makers (especially in the US), might continue to oppose the tax because of the expected negative consequences of an additional distortion. However, criticism will be largely disarmed, because:

• The mechanism would act as an effective monitoring device: especially for OTC-derivatives. Costly and incomplete surveys of all market participants, as currently being conducted by the BIS every three years, will provide the only source of information on the market volume and trends. With the tax, administering it will at the same time allow for automatic statistical reporting of market behaviour, allowing for the easy follow-up of movements in the market and monitoring.




• The Spahn mechanism would not prevent the functioning of the market mechanism: unlike capital controls, the changing target rate allows for market reactions to fundamentals and the sanctioning of policy failures, since it would mean that the exchange rate would lose value steadily. However, changes in value of the currency would be less drastic, avoiding the social costs of a strong and sudden currency crisis, by spreading it out, and allowing the government some (more) time to execute the necessary policy corrections.




• The small tax would not act as a substantial distortion: as such, it would not change current market behaviour. Besides the social justice issue, this is ultimately a matter of weighing costs and benefits. In this case, "perhaps the most effective way of arguing against those concerned with the distortions that a Tobin tax would create would be to determine whether there are alternative methods of raising such amount of money that would be less distortionary" (Frankel [1996,p.64]).




• The mechanism would not necessarily require world-wide approval: to the extent that the mechanism is, in essence, a national tax and is administered nationally, political resistance against loss of national fiscal sovereignty is lessened. More importantly, as a start, the Spahn mechanism could be successfully implemented unilaterally by a few countries, without necessitating global consensus in the beginning.




• The mechanism would not require costly monetary action from the central bank: exchange rates would be kept within the target range through taxation rather than through central bank intervention, which is typically done by using interest rate increases or depleting international reserves. Instead of depleting reserves, it would generate revenues.

A number of additional counterarguments raised against this specific proposal, such as the added complexity due to the use of variable tax rates, can be assessed along with solutions for a number of common technical issues, such as the exact tax rates, tax base, etc. (4). These issues are subject to high-level technical, as well as political, discussion, but do not appear to be insurmountable.

Apart from the more technical issues, a number of elements linked to implementation issues of the working of the Spahn proposition should be tackled. More specifically, it deals with tax collection and administration, tax base, tax distribution and usages of tax revenue. Since these matters are of a more political nature, they are more open to discussion. Some possible general guidelines are being suggested:

With respect to tax base, since the rate is so small, it does not seem appropriate to waiver the tax to many parties engaged, with the exception of central banks, BIS, IMF, etc.

Studies on the technical feasibility of this kind of global tax proposal have shown that a practical way of implementing the tax is to collect it on a market basis and at the dealing site. This means that the tax would be introduced through an international agreement, deriving from its 'global' nature, but revenue collection would be a national responsibility. As such, it seems rather obvious, especially for this tax, that collection would be delegated to the central banks of each country. With the tax collection delegated to central banks, the monetary authorities of the country would have first-hand information on market behaviour, allowing for the easy follow-up of movements in the market and monitoring, not only at the country level, but also internationally, as it allows quick aggregation by the BIS.

While revenue considerations should always be secondary to the use of the CTT to prevent the devastating effects of excessive speculation, the tax proceeds could provide an important additional resource base, calling for a fair scheme of distribution. Two main issues with respect to the distribution of the revenue have to be tackled: one is an element of redistribution caused by the disproportionately high revenue collected in some countries having major financial centres; the other one is the distribution of total revenue between the national and the international level. In fact, it is possible to tackle both issues together.

When tax revenues would accrue on a country-by-country basis, the revenue raised by the basic tax would vary greatly between countries dependent on the importance of the local foreign exchange market. The main financial centres in developed countries, especially in London, New York and Tokyo, would account for most of the revenue. Illustratively, based on the BIS 1995 survey of foreign exchange turnover, the UK would generate about 29% of total tax revenue, while the US and Japan markets would add about 15% and 10% respectively. Developing countries as a group would generate about 14% of total revenue. Among them, countries with regional financial centres, such as Singapore and Hong Kong, would account for the lion's share. As such, for most developing countries, because of the modest tax rate, the national proceeds from the basic tax is likely to be rather small.

As a base for discussion, a fair distribution mechanism could be to allow lower and middle-income developing countries to keep total revenue coming from the basic tax (see also the Kaul & Langmore proposal in ul Haq et.al.[1996], p.267). For high-income countries, (generally also those with important financial centres), a case could be made to make them transfer most of the basic tax revenue, say e.g. 80%, to the global level.

With respect to the surcharge, no estimations of revenue can be made. In fact, ideally, the revenue is nil. A case could be made to allow countries that enter this situation of excessive exchange rate volatility triggering the surcharge mechanism, to keep the full proceeds of it in order to tackle the consequences of the excessive volatility.

However, spending the national component of both basic and surcharge revenue could be made subject to conditionality with respect to its use. Potential uses could be restricted to purposes linked to the problem itself, i.e. investment in the sectors of regulation and strengthening of control of the financial sector and the monitoring of international (especially short-term) capital flows, on the one hand, as well as investment in social safety nets and social development in general, as to reduce vulnerability to the social effects of economic and financial crises.

This leaves the issue of where to administrate and how to use the global component of basic tax revenue. In line with the analysis pointed out in section 1 of this paper, the general suggestion here is to use the proceeds on financing social development needs of poor countries. With respect to locating administration of the funds, a logic corollary of this statement would be to allow funds to be administrated by that institution that can present the best track record in cost-effectively addressing social needs and human development. In practice, this would prove very difficult to assess, also because it is linked to determining, in a more detailed way, what the most crucial element in promoting the broad issue of social development is.

If one thing has become clear from the recent currency and other crises in a number of developing countries and Russia, it is that, currently, one international organisation alone cannot adequately tackle these immense problems. The recent surge of critical voices, especially towards the IMF, has resulted in a large stream of proposals for reform; some marginal, some more profound. However, most of the proposals seem to share the elements of closer concentration of activities; by closer collaboration or the merging of different international organisations, and of an increased role to be played by the representation of developing countries themselves. As such, it is suggested to tackle the delicate issue of administration in light of the further evolution of the debate on reforming the international organisations involved in this debate.

NOTES

1. See e.g. Michalos [1997] for an extensive list of advantages, and a detailed response to all the criticism issued so far. (Back to text)




2. The copybook example is the 'stamp duty' tax in the UK. Not only does it collect a very high yield (about £830 million in 1993), but it is functioning in what is called one of the most sophisticated markets (the City of London) without triggering massive tax evasion as there was no major flight from spot transactions into e.g. derivative transactions, and London remained a major financial center despite it (see Griffith-Jones [1996] for more details). (Back to text)




3. Paul Bernd Spahn is a professor of public finance at the University of Frankfurt/Main and was a consultant to the Fiscal Affairs Department of the IMF at the time of presenting his Tobin-tax variant. (Back to text)




4. One of them is designing an appropriate rate for derivative currency transactions; Spahn's original solution, i.e. to tax derivative transactions at one-half the standard rate, is not appropriate. Given the complexity of some derivatives, it will be difficult to establish one rate for derivatives as one for the underlying that would yield exact tax equivalencies. (Back to text)

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