By Dean Baker
Center for Economic and Policy ResearchMay, 2002
A recent column by an OECD economist ("A Tobin Tax: Could It Work?" by Helmut Reisen), suggested that a tax on currency transactions would be difficult to enforce, and probably a poor source of revenue to finance development. It raised several issues that deserve further consideration.
On the question of enforcement, Mr. Reisen warned of both geographical avoidance (i.e. trades taking place in tax havens where the tax is not enforced) and avoidance by trading in untaxed derivative instruments, such as futures, options, and swaps.
These are legitimate concerns, but they could be raised against almost any tax. For example, at present many U.S. corporations are now re-incorporating in Bermuda or other tax havens in order to avoid most of their income tax liability. While this could be viewed as an argument against the income tax, the alternative is legislation that would prohibit this sort of gaming of the system (which has been proposed in the U.S. Congress).
Similarly, it would be possible to avoid geographical gaming of a Tobin tax by making all nationals and corporations within the jurisdiction of the tax (e.g. the European Union), subject to the tax on all trades they make, regardless of the location. Denmark had a similar tax in place on stock transactions until the early nineties.
The point about the tax leading traders to shift to derivative instruments is well-taken. While some supporters of the Tobin tax point out that these trades would still be subject to the Tobin tax, if they led to spot transactions (actual trades of currency), the vast majority of derivative trades never result in spot transactions. This means that the impact of a Tobin tax on the trading costs of derivatives would be minimal.
But, this can be answered easily enough by extending the tax to these derivative instruments. The trade in currency options, futures, swaps and other instruments is no more desirable than the trade in currency itself. Taxing trades in these instruments could raise tens of billions of dollars of additional money to finance development. (Some proponents of Tobin taxes would like to see domestic financial transactions, like the sale of stocks and bonds, also subject to taxes, as is currently the case in many major countries, such as England and France.)
It is worth placing the general issue of enforcement of a Tobin tax in context. The incentives to evade a tax are proportional to its size. Also, a tax on a highly concentrated market is much easier to impose than a tax on highly decentralized transactions. If a Tobin tax is compared to copyrights -- which can be seen as a tax which is privately collected -- then it appears that Tobin taxes are far more enforceable than copyrights.
As far as the size of the tax, most proponents recommend a tax rate of 0.1 percent for the Tobin tax. By contrast, copyright is effectively a 100 percent tax. Software, recorded music and video material would be available at no cost over the web in the absence of copyright protection. The entire price of the product is due to copyright enforcement. This means that the incentives to evade copyrights are far greater (by several orders of magnitude) than the incentives to evade a Tobin tax.
Most currency trading is done by large financial institutions that trade hundreds of millions or even billions of dollars of currency every day. This should make detection of evasion relatively simple. It is a standard practice in tax enforcement to offer informants a percentage of the taxes collected. If a bank or brokerage firm owes tens of millions of dollars in Tobin taxes, it seems likely that it will have a clerk who would be willing to report tax cheating by his or her boss, in exchange for a few million dollars. While evasion on some amount on smaller trades will surely go undetected, it doesn't seem likely that major financial institutions will be able to practice large-scale evasion for any significant period of time.
By contrast, the reproduction of copyrighted material is potentially a completely decentralized process, with individuals copying software or recorded music for their own use. There is no need for concentration in the copying of copyrighted material. However, in spite of the large incentives to evade copyrights and the decentralization of the process, copyrights are still largely enforced. This is easily demonstrated by the fact that Microsoft is one of the most profitable companies in the world. Since it gains almost all of its revenue from the sale of copyrighted material, its existence is a testament to the enforceability of copyrights.
The other point raised in Mr. Reisen's piece -- that currency trading is likely to diminish, therefore leaving a smaller tax base - can actually be viewed as argument for the tax. Most proponents of Tobin taxes view the large volume of currency trading as a source of instability in the financial system. Insofar as this is the case, reducing the volume of trading could lead to more stable financial markets.
But, let's assume that the volume of trading has no direct relationship to instability. The trading itself still presents a cost to the economy, in the sense that it uses resources - labor and capital - which could instead have been used somewhere else in the economy. If the volume of trading falls due to the imposition of a Tobin tax, then this means that less resources will be wasted in trading. Since all the costs of trading are passed on somewhere (no one trades for free), trading costs eventually show up in the prices charged by banks, insurance companies and other financial institutions.
This means, that if Mr. Reisen is correct, and the tax leads to a very large reduction in trading volume, then the cost of the tax will be borne almost completely by the financial sector itself, and not passed on to consumers in the form of higher prices. For example, let's assume that current trading volume is $300 trillion annually (approximately the current volume of trading in the spot market), that trading volume falls by three quarters as a result of a 0.1 percent Tobin tax, and the average cost of a trade is 0.05 percent. In this case, the amount of money spent on direct trading costs would be reduced by $112.5 billion as a result of the tax (costs would fall from $150 billion to $37.5 billion, as trading volume feel from $300 billion to $75 billion). The tax would then raise $75 billion a year in revenue (0.1 percent on the $75 billion in trade volume left after the tax). In this case, the total amount spent in trading costs (direct costs plus the tax) would actually drop by $37.5 billion ($112.5 billion in reduced savings costs minus $75 billion in taxes). This means that tax would be fully financed from the savings in trading costs. There would be no additional costs to pass on to consumers. In fact, the costs that bank, insurance, and brokerage firms charge to firms and individuals may actually fall, along with their expenses.
In short, the potentially sharp drop in trading volume that Mr. Reisen views as a problem of a Tobin tax is actually one of its virtues. It means that very little, if any, of the revenue raised by the tax will be passed on to consumers, instead it will be borne by the financial industry. The tax could lead to a reduction in some hedging that firms do to protect themselves against unexpected market fluctuations, but we know with absolute certainty that firms assign very little value to this insurance - if they valued it at rate of more than 0.1 percent of the face value, then the tax would not be large enough to prevent the hedge.
It is encouraging to see the OECD raising substantive issues concerning the merits of a Tobin tax. It is important that proponents of a tax are prepared to address such issues. In this case, it does not appear that the issues raised by Mr. Reisen seriously undermine the case for the Tobin tax.
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