Why ‘Tobin Tax’ makes sense in today’s world

It is meant to help curb short-term speculation on currency transactions

Investors, Wall Street executives and market makers in the US have been debating the imminent introduction of currency transaction tax, or ‘Tobin Tax’, in recent months, following statements on it from Biden administration officials. The debate on whether to levy Tobin Tax or not has been raging for decades and has been an issue of dispute between some liberal economists and policymakers on one side and Wall Street participants on the other side.

James Tobin, the American economist and winner of the Nobel Prize for Economics in 1981 proposed the tax on currency transactions in 1978. It was meant to discourage short-term speculation in currency markets that caused erratic fluctuations in exchange rates, causing significant damage to economies.

When Richard Nixon suspended the convertibility of the US Dollar into gold in 1971, he effectively ended the fixed exchange rate system established under the Bretton Woods system and signaled the move to a flexible exchange rate system. As a result, there was a massive movement of funds between different currencies that threatened to destabilise the economies of many countries. Having got used to the floating exchange rate system and the volatility associated with it, Wall Street scoffed at the idea of a Tobin Tax which aimed at curbing speculation. As someone put it succinctly, “the bulk of the participants have a vested interest in the instability of forex markets as high turnover tends to occur only when markets are volatile.” The analysts at Salomon Brothers hit the nail on the head when they contended that “logically, the most destabilising environment for an institutional house is a relatively stagnant rate environment.”

Tobin had suggested a rate of 0.5 per cent on short-term currency transactions and had argued that the tax would be effective only if all countries adopted it and the revenues were donated to developing economies since they were affected the most by volatile exchange rates and capital outflows. Although the rate proposed by Tobin was low, substantial revenues could be garnered as forex transactions between countries have grown multifold, thanks to globalisation.

Supporters claim that the tax would help stabilise currency and interest rates and would provide relief to the central banks of economies that do not have the reserves to arrest a currency sell-off. The appeal of Tobin Tax consists in being a disincentive to short-term transactions while not hampering normal international trade. Tobin contended that the instability in markets was caused by asymmetric information and herd behaviour among speculators.

Though the original objective of the tax was to curb speculation in short-term currency transactions, different countries implementing it have used it to their advantage to justify the levy. Many countries in Europe have imposed a levy on transactions of financial assets like shares and bonds. India, too, has a kind of Tobin Tax called the Securities Transaction Tax (STT), which is levied on the purchase and sale of securities like equity shares, debentures and units of mutual funds. The government has been collecting substantial amounts through STT because of the higher retail participation on the back of the stock markets scaling new heights. The government collected an STT of Rs 5,178 crore for the first quarter of FY 2021-22 against the full-year target of Rs 12,000 crore. Incidentally, the amount collected was Rs 2,408 crore during the corresponding period last year. These taxes have helped governments the world over to use the revenues to tackle problems like environmental pollution and poverty, which is why it is sometimes also called Robinhood Tax. Some countries, such as Chile, insist on a deposit of 30 per cent on the inflow of capital held for one year, and the policy has been used as a deterrent and has provided stability to short-term exchange rates.

Opponents of Tobin Tax argue that the motivations of different traders in financial markets are not well understood and taxing all short-term transactions is harsh as they provide liquidity to currency markets. They say that the tax would eliminate the profits of traders and reduce the volume of transactions. They also argue that there is little evidence to suggest that Tobin Tax can reduce market volatility and prevent speculative attacks on currencies. There is also the problem of getting countries to agree on a uniform rate of tax. The sharing of revenues between countries and the United Nations will be another contentious issue.

To quote a paper written for Oxfam, “Any proposal on the distribution of tax revenue can be expected to encounter stiff opposition from one quarter or another. Countries that are currency trade centres will want to keep the money for themselves, developing countries will want resources for development, and the major industrialised countries will not wish to relinquish the purse strings of multilateral organisations.” This pretty much sums up why there is no global Tobin Tax today. Let’s see if Biden gets it going.

(The writer is a CFA and a former banker. He currently teaches at Manipal Academy of BFSI, Bengaluru)