Global Policy Forum

By Graham Bird and Ramkishen S. Rajan

1. Introduction
Since 1992, crises in global financial markets have been the norm rather than the exception. Specifically, in 1992-93, Europe was faced with the virtual collapse of the European Exchange Rate Mechanism (ERM). In 1994-95, there was the Mexican currency and financial crisis, which saw the steep devaluation of the peso, and there were also negative contagion effects on Argentina and Brazil (so-called 'Tequila effect'). Since mid 1997, the world has been experiencing the effects of the East Asian crises, which started somewhat innocuously with a run on the Thai baht, but spread swiftly to a number of other regional currencies (so-called 'Tom-Yam effect'). As the five crisis-hit East Asian economies (viz. Indonesia, Korea, Malaysia, Thailand and, to a lesser extent, the Philippines) saw a single year capital reversal of about $105 billion between 1997 and 1998, the socio-political repercussions that the crises have had on the East Asian economies have been far reaching. And, most recently, in January 1999, the Brazilian real was devalued, losing over about 40 percent of its value relative to the US$ within two months.

These global crises - and particularly the ones in East Asia - have led to a heightened awareness by policy-makers and academics of the existence of 'problems' in the international monetary system. Consequently, in conjunction with appropriate domestic policies (such as enhanced transparency and prudential regulations), an unusually high degree of support seems to have been generated for examining how to reconstruct the current global financial architecture, so as to reduce the chances of financial crises occurring in the future, or, at least, to reduce their severity if and when they do occur. One element of the reforms that has received much attention involves "sprinkling sand in the wheels of international finance" through the imposition of a tax on currency transactions, so as to moderate cross-border capital flows and foreign exchange (forex) instability (1).

2. The Tobin Tax Proposal
The 'first best' rationale for such levies (on a permanent basis) is based on capital market distortions. These include the existence of multiple equilibra in forex markets and the herd behaviour of financial market participants. The 'second best' rationale (for temporary controls) includes the possibility of 'over-borrowing' due to incomplete or inappropriately sequenced financial sector reforms (including inadequate prudential regulations) and 'over-lending' due to implicit and explicit government guarantees, cronyism and the like. These distortions give rise to dramatic boom-bust cycles of sudden surges in capital inflows followed by dramatic capital reversals as euphoria turns to panic. A currency crisis thus ensues, culminating in banking and financial crisis, with potentially calamitous consequences for the real economy. But how can such boom-bust cycles be avoided?

There are broadly two ways of doing so. The first is to directly control market movements. The second is to use a market-based mechanism to alter the structure of price incentives that face market participants, thereby inducing them to modify their behaviour. The administrative requirements, incentives created for rent-seeking activities, and the general 'porousness' of quantitative restrictions, particularly in the medium- and longer-terms, on the one hand, and the potential for generating tariff revenues on the other, have generally led economists to prefer cost-based levies over quantitative restrictions. This is where currency taxation comes into the picture.

A tax on international forex activities was originally proposed by Nobel Laureate James Tobin in 1978. The so-called Tobin tax is essentially a permanent, uniform, ad-valorem transactions tax on international forex flows. The burden of a Tobin tax is claimed to be inversely proportional to the length of the transaction, i.e., the shorter the holding period, the heavier the burden of tax. For instance, a Tobin tax of 0.25 percent implies that a twice daily round trip carries an annualised rate of 365 percent; while in contrast, a round trip made twice a year, carries a rate of 1 percent. Accordingly, and considering that 80 percent of forex turnover in 1995 involves round trips of a week or less, it has been argued that the Tobin tax ought to help reduce exchange rate volatility and consequently curtail the intensity of 'boom-bust' cycles due to international capital flows.

3. What does Available Research Tell us about the Tobin Tax?
The currency crises of the 1990s and the wild gyrations in global forex markets, have provided the impetus for a resurgence of interest in the Tobin tax(2). The political economy of currency taxation suggests that it will receive greater support if it can be shown to make a significant contribution to offsetting the perceived inefficiencies of private international capital markets. Based on available research on the topic, the following policy conclusions may be drawn.

3.1 Geographical Coverage
The Tobin tax cannot be applied unilaterally, as this will merely lead to a migration of forex transactions to untaxed countries (i.e., avoidance via migration). However, as long as the Tobin tax is levied on the trading site rather than the booking or settlement site, the high fixed costs involved in developing the human and physical infrastructure, ought to act as a disincentive against migration. Accordingly, rather than being completely universal (in the sense of including all countries), the Tobin tax need only be imposed by all the major financial centres in a uniform manner (3).

3.2 Asset Coverage
If the Tobin tax is limited to spot transactions (as per Tobin's original suggestion), this will lead to a tax-saving reallocation of financial transactions from traditional spot transactions to derivative instruments. As such, to prevent tax avoidance via asset substitution, it ought to be applied on all derivative products such as forwards, futures, options and swaps.

3.3 Tax Rates
While much research needs to be done in order to determine issues such as the optimal tax rate, coverage, and the like, there is broad consensus that the tax must be levied at a rate designed to minimises the incentive to undertake synthetic transactions in order to evade the tax (i.e., geographical or asset substitution) or to alter the forex market structure from a decentralised, dealer-driven market to one that is centralised and customer-driven. Suggestions of the 'most appropriate' rate of taxation have generally ranged between 0.1 and 0.25 percent.

3.4 Preventive Rather than Curative
A Tobin tax will probably be far more successful in (and ought to be aimed at) moderating (short-term) capital inflows (especially debt financing), rather than outflows. In other words, the aim should be to prevent excessive 'booms' from occurring in the first instance, rather than attempting to mitigate the effects of (let alone, eliminate) the 'busts' that invariably follow.

While it is certainly true that the annualised rate of tax varies positively with the speed of the round trip, in an important sense, this is irrelevant. What really matters is whether the expected gains exceed the costs defined to include the payment of the tax. In the midst of an international financial crisis when its stabilising properties are most needed, a currency tax will be least effective, because of the large expected gains from speculation. Tobin (1996, p.xi) noted that "the essential property of the transactions tax - the beauty part" is that "this simple, one-parameter tax would automatically penalise short-horizon round trips, while negligibly affecting the incentives for commodity trade and long-term capital investments." However, insofar as agents engaged in international trade in goods and services, foreign direct investment (FDI) and other 'productive' cross-border activities hedge their financial transactions, while those engaged in portfolio flows that are short-term in nature ('speculators') do not, it is possible that the Tobin tax ends up being relatively more burdensome on the former. This conclusion is arrived at by assuming that each hedging operation requires four or more financial transactions (each of which would be taxed). In contrast, speculative transactions involve only two (i.e., round-trip) cross-border flows. As such, to the extent that long-term capital flows are more 'conducive' to economic growth than short-term ones, application of the Tobin tax in a pro-cyclical manner would not just be ineffective, it could actually be growth-reducing.

3.5 Counter-cyclical rather than Pro-cyclical
Given the above (preventive) objective of a Tobin tax, it needs to be imposed in a counter-cyclical manner, i.e., raise the tax rate during a boom period and lower it (even eliminate altogether) at other times. This is consistent with the Chilean experience with and management of its interest-free deposit requirement(4); as well as the empirical literature on capital restraints, which seems to indicate that capital controls have been more effective at preventing 'excessive' capital build-up than at stemming capital flight.

4. Cashing in on Capital Volatility
What if speculative capital movements are insensitive to relatively low rates of currency taxation? After all, there is growing evidence that while the reserve requirements in Chile and other types of capital controls are effective in lengthening the maturity structures of capital flows, they have negligible impact on the volume of aggregate capital flows. In fact, a one percent increase in the (implicit) Chilean tax has been found to have a greater impact when trend economic growth is low than when it is high. In other words, capital controls are least effective as an instrument for stabilising capital flows when most needed.

To the extent that this finding holds true for the Tobin tax, does any rationale for it remain? While the low elasticity of capital movements with respect to currency taxation is a disadvantage from the viewpoint of calming markets and avoiding crises, it is an advantage in terms of generating revenue. Rather than reducing capital volatility, the strength of the argument for currency taxation therefore lies in cashing in on it. From this perspective, the low elasticity is exactly what is needed. Indeed, we have a win-win situation. After all, governments tax many activities that have negative externalities, such as smoking. If cigarette taxes are effective in stopping people from smoking, that is good news. If they are ineffective, that is also good news in as much as the tax will generate revenue, part of which may be used to finance the cost of providing health care for smokers either directly or indirectly (given the fungibility of money). This analogy may be applied to currency taxation.

4.1 Revenue Potential of a Tobin Tax
Estimating the revenue from currency taxation is a complicated methodological exercise since much depends on the rate and coverage of the tax, as well as the extent of tax evasion and avoidance. Table 1 summarises the estimates of tax revenue generated from the available studies, based on tax rates between 0.1 to 0.25 percent.

Given these studies, it may be reasonable to assume that a transactions tax of 0.25 per cent will generate an annual revenue of (say) $150 billion. This is probably a fairly conservative estimate, given that the cited studies have been based on 1995 figures of daily global forex turnover (of about $1.2 trillion excluding derivatives), as opposed to the higher 1998 figure (of about $1.5 trillion).

The important point, however, is that the case for the Tobin tax does not depend centrally on sophisticated and complex calculations of tax rates and elasticities. If the tax elasticity is relatively high, the effect may be to stabilise forex markets, and its preventive role will be effective. If however the elasticity turns out to be relatively low, though the preventive role will be ineffective, there will be a relatively large amount of revenue generated.

5. A Global Tax for Global Purposes
Detailed discussion of the potential uses of the Tobin tax revenue are beyond the scope of this article. Generally, the revenue could be used to finance global public goods, including foreign aid (5).

While there is much scope to debate what activities should be financed from Tobin tax revenue, an important analytical point is that the more compelling financial centres find the uses to which the revenue from an international currency tax will be put, the more prepared they will be to support the idea. It is therefore essential that the currency taxation proposal, which, after all, has been around for some time, be made attractive to the international community. This might be done by presenting it as a way of dealing with a new global problem rather than merely a new way of dealing with an old one. The Tobin tax has conventionally been presented as a preventive measure directed at reducing volatility, stabilising capital movements and avoiding financial crises. However, more appropriately, it should be seen as an instrument for helping to deal with financial crises once they have happened. In this regard the revenue could perhaps be used to help finance a new international lender of last resort (ILLR). However while a Tobin tax will generate a large amount of revenue in absolute terms, the revenue will not be large relative to the size of international capital markets and this will constrain the confidence-creating function which lies at the heart of an ILLR.

It may therefore be better to use the revenue to augment the resources of the IMF since the Fund's high profile role in East Asia has exposed its vulnerability to illiquidity and the shortcomings of its existing methods of increasing its resource base by quista reviews which are themselves influenced by political factors and hurriedly negotiated supplementary arrangements such as the New Arrangements to Borrow (NAB). By linking them to a Tobin tax, the Fund's resources would tend to rise at precisely the time when greater claims were being made on the Fund as a consequence of an international financial crisis.

6. Summary and Concluding Remarks
With the ever-escalating frequency and intensity of financial crises, they can no longer be dismissed as mere aberrations in an otherwise well-functioning global capital market. While emphasising the need for measures to enhance the soundness of banking and financial systems (particularly prudential supervision), the ferocity of the East Asian crises has belatedly but surely awakened policy-makers to the need to "reform the global financial architecture". Though this term is admittedly (and intentionally?) vague, one aspect of the reforms often discussed has been the possible introduction of some frictions into the wheels of international finance.

In principle, currency taxation could reduce international capital volatility by mitigating a build up of capital inflows (i.e., a 'boom'), as opposed to slowing the speed of outflows during a period of extreme bearishness (i.e., a 'bust'). Even if it is ineffective at this goal, there is reason to believe that the tax has significant revenue-generating potential. This becomes particularly appealing and important at a time when serious doubts are being raised about the ability of the IMF to generate sufficient financial resources to deal with the next crisis, if and when it occurs. The revenue would further allow the Fund to direct a larger proportion of its existing resources to low income countries where capital volatility is less of a problem and where the effectiveness of IMF-backed programs may well be positively associated with the amount of finance provided.

In the final analysis, while the Tobin tax and similar proposals have been around for some time, the depth and breadth of the East Asian crises have provided a genuine opportunity for the issue to be examined in a serious and non-ideological manner. Failure to consider systematic and uniform responses to the increasingly obvious market failures in the international monetary system (such as the Tobin tax), may force countries under stress to pursue ad hoc, unilateral polices, such as the recent exchange controls imposed by Malaysia. This is surely a far less desirable alternative for the global economy.

Bibliography
1. Bird, G. and R. Rajan (1999). "Coping with and Cashing In On International Capital Volatility", mimeo, University of Surrey and Claremont Graduate University, California, March.

2. D'Orville, H. and D. Najman (1995). Towards a New Multilateralism: Funding Global Priorities, New York: United Nations.

3. Felix, D. and R. Sau (1996). "On the Revenue Potential and Phasing In of the Tobin Tax", in ul Haq et. al. (eds.), op. cit..

4. Tobin, J. (1978). "Proposal for International Monetary Reform", Eastern Economic Journal, 4, pp.153-9.

5. ul Haq, M., I. Kaul and I. Grunberg (eds) (1996.) The Tobin Tax: Coping with Financial Volatility, Oxford University Press

1 Other issues discussed under the umbrella of a "new global financial architecture", include reform of the IMF and World Bank, possible creation of an international lender of last resort facility (or redefining the IMF's role as such), establishing international bankruptcy procedures, formalizing a mechanism for burden-sharing between private debtors and creditors, and the like. back

2 See for instance the papers collected in the United Nations Development Program-sponsored book (ul Haq, et al., 1996). back

3 In 1998, the top two financial centers (viz. UK and US) accounted for half of global forex turnover, while the top 10 accounted for 86 percent of aggregate turnover. back

4 Specifically, the Chilean deposit requirement (known as 'encaje') was initially increased from 20 to 30 percent of capital inflows in May 1992. It was subsequently reduced to 10 percent as of June 26, 1996 in response to a general slowdown in portfolio capital inflows to all emerging economies. back

5 See Bird and Rajan (1999) and references cited therein. back

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