June, 1999
In the course of the Asian crisis, there were increased calls again for restrictions on the movement of capital, especially short-term capital. Such demands have often been made in the past after a serious currency and financial crisis and have a long tradition in economics. In recent years, they have played an increasingly important role since the volume of short-term international liquidity has risen significantly both in absolute terms and compared to the international flow of goods. Thus far, however, such considerations have prevailed neither in the theoretical debate nor in economic policy, because the advantages of free capital movement obviously outweigh the disadvantages.
The latest proposals by well-known economists to prevent crises by regulating short-term capital flows are based on an idea of the Nobel prize winner for economics, James Tobin, dating back to 1978. His proposal for a tax on foreign exchange transactions is closely linked to the failure of the Bretton Woods System in the early 1970's. To block what he perceived to be welfare-reducing speculative capital flows and to put a brake on "overly" efficient international capital markets, Tobin recommended taxing foreign exchange transactions.1) Such a tax, intended as an alternative to a (global) single currency, was to curb speculative currency transactions and to enable central banks or monetary authorities to pursue an interest-rate policy that puts greater emphasis on domestic issues. Tobin proposed to levy the tax worldwide, i.e., not to allow "tax havens", and to fix a uniform tax rate (for example taxing each currency transaction, such as spot deals, forward exchange transactions, currency options trading or currency swaps, at a rate of 0.5%). His idea was to use the proceeds from this international tax for international purposes, e.g., to finance UN projects or development and environmental measures. With a daily turnover of US $ 2,337bn (BIS, April 1998) in international foreign exchange markets, the Tobin tax would generate daily revenues of about US $ 11.7bn based on a tax rate of 0.5%. However, since we can expect the price elasticity of currency trading to be high, the steering effect of the tax would probably be fairly large, with corresponding negative consequences for tax revenue.
A hypothetical example shows that the Tobin tax (rate of 0.5%) is the more effective, the shorter the contract maturity. The base for our calculations is a currency transaction that is taxed twice, i.e., at 1%. At a domestic reference interest rate of 10%, the return on the speculative currency would have to be at least 11.1% based on a 12- month investment. If the position were only held on a day-to-day basis, the annualized rate of return would have to be 372.8%. This shows that even taking advantage of large interest differentials becomes unprofitable, which in turn prevents short-term (speculative) capital flows. The example of Colombia illustrates the effectiveness of the tax. The tax on financial and currency transactions levied by the government since the fall of 1998 acts like a capital control and limits short-term capital flows: turnover in the Colombian foreign exchange market has fallen to one-tenth of its original level.
However, there are several arguments against the Tobin tax: levying such a tax would be costly and complicated, and the high tax revenue would cause greediness. In any case, it would probably be almost impossible to reach an international consensus. Moreover, countries that suffer from external imbalances and therefore use high interest rates to attract foreign capital would have to raise their interest rates further by the amount of the Tobin tax, with accordingly bad economic consequences. Furthermore, such a tax would hurt market efficiency since - economically speaking - it is hard to distinguish between positive and negative speculation.
A positive effect of the Tobin tax would be that it would ease the pressure on the currencies of the emerging markets arising from speculative capital flows. However, the concept diverts our attention away from the true problems: in order to avoid future crises, it is necessary to improve the credibility and predictability of economic policy, monetary transparency and the efficiency of the banking and financial sector, including financial market supervision. By contrast, both the Tobin tax and the idea of capital controls rather try to cure the symptoms. Restrictions on capital movements should at best be used for short-term stabilization; they cannot replace economic reforms.
1) See Tobin, James: A Proposal for International Monetary Reform, Cowles Foundation Discussion Paper 506, Yale University 1978. Copyright: Dresdner Bank AG. All rights reserved. Dresdner Bank and JMIS assumes no liability with respect to the contents.
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