Global Policy Forum

By Rodney Schmidt

Summary

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In the 1970s, Nobel Laureate James Tobin suggested imposing a small tax on all foreign exchange transactions to slow down speculative trades in the foreign exchange market. The order of magnitude for such a tax would be around 0.1 percent, or US$1,000 per million dollars sold. Although this would be a negligible cost for long-term investors, for speculators flipping currencies weekly or daily, it would amount to an onerous tax of 10 to 50 percent on their investment.

An important part of the attraction of the Tobin Tax is that it alters economic incentives, rather than requiring a "command and control" approach to regulating capital flows. As such, it is similar to taxes applied to control other forms of "externalities," for example, pollution. By imposing taxes on pollution emissions, polluters would be induced to lower their pollution levels or else suffer lower profits. Similarly, a Tobin Tax would aim to lengthen the horizons of international investors by making short-term transactions relatively less profitable.

Much of the criticism of the Tobin Tax has focused on its technical feasibility. With US$1.3 trillion changing hands daily in foreign exchange markets, the sheer enormity of imposing the tax is forbidding. For example, many people believe that a tax on foreign exchange transactions could easily be evaded by shifting foreign exchange trading activity offshore or by using derivatives and other financial instruments to disguise trades in foreign exchange. Recent research by the North-South Institute, however, suggests that the tax is feasible if it was applied to the interbank payments made to settle foreign exchange transactions rather than to the trades that define the transactions.

Foreign exchange transactions are settled when the traders involved each pay the traded currency to the other. Because the infrastructure for settling foreign exchange trades is formal, centralized, and regulated, it is possible to monitor and access most interbank foreign exchange payments, regardless of the financial instrument used to define the trade, where the parties to the trade are located, or where the ensuing payments are made.

There are two ways to make interbank foreign exchange payments: make them directly in the domestic payment system of the country that issues the traded currency; and to periodially net offsetting payments in offshore netting systems or securities clearing houses. Usually both methods are used sequentially: offsetting payments are eliminated and the resulting net amounts owing are made in domestic payment systems.

For Tobin's tax to be feasible, it must be possible to tax individual foreign exchange payments in both offshore netting systems and domestic payment systems, and enforce the tax in these systems. Three features of the current settlement infrastructure of the interbank foreign exchange market accomplish this.

Domestic payment systems can identify and tax foreign exchange payments because they process payments individually. This means that they can trace domestic financial payments to the originating trade. If a payment is not traced to a domestic financial transaction, it is because it is a foreign exchange payment and may therefore be taxed. By mid-2000, domestic payment systems will also be able to directly identify foreign exchange payments by tracing them to the originating trade.

Offshore netting systems also individually process payments submitted for netting and trace them to the originating foreign exchange trade before netting. Hence, they can also identify and tax foreign exchange payments.

Central banks or their supervisory bodies regulate offshore netting activity and enforce regulations. The same mechanisms could be used to enforce a foreign exchange payments tax.

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