Global Policy Forum

Destabilizing Speculation and the Case for an International Currency Transactions Tax


By Thomas I. Palley

Assistant Director of Public Policy, AFL-CIO

June 2000

The international financial instability of the last several years has prompted calls for a new international financial architecture. Often included in proposals for this new architecture is a tax on international currency transactions, commonly known as the Tobin tax. Proponents argue that a Tobin tax would help reduce financial instability and is feasible. Opponents counter that it is infeasible, and could even worsen instability. This article examines the case for a Tobin tax, and argues that it is both desirable and feasible.

The intellectual history of the Tobin tax

The idea of an international currency transactions tax was first advanced by Nobel laureate economist James Tobin (1978) who proposed a small tax - these days the suggestion is 1/10 percent - on all foreign exchange (FX) dealings. The intention was to reduce disruptive speculation in FX markets by raising the cost of engaging in such activities.

The Tobin tax builds on an earlier proposal made by Keynes (1936) in his magisterial book, The General Theory of Employment, Interest, and Money. In The General Theory Keynes proposed the imposition of a small transactions tax on all stock exchange dealings to diminish instability in domestic stock markets. His proposal was motivated by the disastrous consequences of the stock market crash of 1929, combined with the observation that speculation tended to be more prevalent on Wall Street then on Throgmorton Street (the London stock exchange) in part due to the absence of a tax in the New York market.

"It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is compared with Wall Street to the average American, inaccessible and very expensive. The jobber's "turn", the high brokerage charges and the heavy transfer tax payable to the exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market to rule out a large proportion of the transaction characteristic of Wall Street. The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States (Keynes, 1936, p.159-60)."

More recently, following the U.S. stock market crash of 1987, the idea of using transactions taxes to curb speculation received support from Joseph Stiglitz (1989), the former Chairman of the U.S. Council of Economic Advisers and former Chief Economist of the World Bank. It also received support from Lawrence Summers (1989), the current U.S. Treasury Secretary. The bottom line is that the Tobin tax has a highly respectable intellectual heritage. Though this does not make the Tobin tax necessarily right, it does dispel the notion that it is an outlandish idea.

Why the revival of interest in the Tobin tax

The current revival of interest in the Tobin tax is the result of events of the last few years. In 1994 Mexico was hit by a major financial crisis. Not only did this crisis hurt the Mexican economy, it also hurt all of Latin America which was infected by a process of financial contagion (the "Tequila" effect). In 1997 financial crisis again erupted in East Asia, this time pulling down the economies of South Korea, Thailand, Indonesia, and Malaysia. In 1998 Russia was hit by financial crisis, and this was followed by a financial crisis in Brazil in 1999. The belief is that all of these crises were either triggered or exacerbated by financial speculation, and that measures to reduce speculation, such as the Tobin tax, would have helped avoid the crises or reduced the extent of resulting damage.

It is not only developing countries that have been hurt by currency speculation. Developed countries, including the U.S., have also been injured. In the wake of the Russian financial crisis of summer 1998, Wall Street was rocked by a crisis of its own. The Russian crisis generated a wave of unpredictable movements in interest rates which pulled down the hedge fund Long Term Capital Management (LTCM). The crumbling of LTCM's financial position in turn threatened to pull down the entire market owing to the extent of LTCM's borrowings and the exposed nature of its financial positions, and this necessitated the Federal Reserve intervening to co-ordinate a private sector funded bailout of LTCM.

U.S. manufacturing industry was also badly injured by the east Asian financial crisis. U.S. exports to the region fell as east Asian currency values plummeted relative to the dollar and east Asian economies went into recession, while U.S. imports from the region surged. The result was a massive increase in the U.S. trade deficit that was accompanied by the loss of half a million manufacturing jobs.

Similar damage had been inflicted on U.S. manufacturing fifteen years earlier when the dollar underwent a prolonged period of over-valuation that made U.S. manufacturing internationally uncompetitive. In the U.K. there have been similar problems both in the early 1980s and late 1990s, when the pound sterling appreciated thereby making British manufacturing uncompetitive.

Finally, for much of the 1980s Europe's economy was adversely impacted by governments' fear of currency crisis. To avoid this, many European governments raised interest rates to shore up their currencies, but the result was higher interest rates which contributed to high unemployment. Though the introduction of the Euro has helped reduce this problem by reducing the scope for currency crises amongst small European economies, it does illustrate how even developed countries can be hurt by currency market speculation.

Why the Tobin tax can help reduce harmful speculation

Before detailing how the Tobin tax can help reduce disruptive speculation, it is worth making two important points. First, a Tobin tax will work best when introduced as part of an overall financial architecture, and this is why proponents usually present it as part of a package of reform measures. This feature reflects the fact that policy measures often exhibit synergies so that the whole is frequently greater than the sum of the parts.

Second, the Tobin tax and other measures to reduce disruptive speculation do not prevent bad outcomes resulting from bad policy. For instance, a major reason for the damaging appreciations of the dollar and the pound sterling in the 1980s was tight monetary policy in the U.S. and U.K. respectively. This raised interest rates and attracted an inflow of foreign capital that appreciated the exchange rate. This would likely have happened even in the presence of a Tobin tax, though it is possible that the inflows would have been marginally dampened.

Similarly, a Tobin tax would not prevent exchange rate collapses resulting from government attempts to maintain fixed exchange rates that are massively over-valued relative to the rate warranted by economic fundamentals. Critics of the Tobin tax often point to the fact that the tax is so small (1/10 percent) that it would not deter speculators from attacking over-valued fixed exchange rates where they anticipate double-digit percent gains. However, such criticism misses the point. The Tobin tax is not intended to prevent speculation resulting from massive policy induced exchange rate overvaluation: instead, it is intended to prevent groundless speculation that increases noise in financial markets and imposes costs on other sensible investors.

The traditional "Chicago School" view of speculation is that speculation is stabilizing (Friedman, 1953). This Chicago point of view is predicated on the argument that there exists a market price which is warranted by economic fundamentals. When the actual price exceeds this warranted price, speculators realize that the market is over-valued. They therefore sell, and drive the market down to its warranted price. Conversely, when the actual price is below the warranted price, speculators realize the market is under-valued. They therefore buy and drive the market up to the warranted price.

This traditional "Chicago School" view has been challenged from a number of directions. One challenge comes from the Chicago School's own rational expectations theory of behavior which shows how asset price bubbles can be rationally self-fulfilling. All that is needed is that market participants expect that the future price will be higher, and they will then buy now on anticipation of this higher future price. In this fashion "market beliefs" become the driving fundamental, and if speculators share and shape this belief they can drive prices away from the level warranted by economic conditions.

A second challenge comes from the noise trade literature (De Long, et al., 1990) which shows that market participants who trade purely on the basis of noise may come to dominate the market. This is because noise traders are unconcerned about risk, and therefore earn a higher rate of return then ordinary persons who are concerned about risk. In this fashion, noise traders come to dominate the market, and though the market remains stable, it produces socially sub-optimal outcomes.

A third challenge comes from the literature on herd behavior (Banerjee, 1992; Palley, 1995). which posits that market investors may rationally act as a herd. Each individual acts rationally from his or her own standpoint, but collectively they behave as a herd, each following the actions of others for no reason other than the fact that others are doing it. In this case, the "behavior of others" becomes the market fundamental, and the actions of speculators can trigger movements in market prices through random dealings that have no relation to underlying economic conditions.

A fourth strand of work explicitly aimed at justifying a Tobin tax focuses on how speculators may cause damage to other market participants when they cash out of their investments (Palley, 1999a). This seems to have been particularly prevalent in east Asia, where the decision to cash out and repatriate investments led to a fall in the exchange rate that then increased the debt burden of those east Asian entrepreneurs who had used foreign currency borrowings to finance their business expansions. In such instances, speculators impose a negative externality on other investors. These other investors (call them fundamentals investors) are in for the long haul, and their investment calculus is thereby compromised. Conventional economic theory advises that policy makers should tax activities having negative externalities, thereby making them more expensive and discouraging them. This is well-known theory of Pigouvian taxes, named after the English economist A.C. Pigou. Viewed from this vantage, the Tobin tax is a form of Pigouvian tax that is applicable to international financial markets.

The correction of negative externalities provides one economic justification for the Tobin tax. A second justification is that it may reduce exchange rate volatility which has damaged manufacturing employment, and also likely reduced economic efficiency by increasing uncertainty surrounding investment decisions. Here, it is worth distinguishing between short- and medium-term volatility. The former concerns within day and day-to-day exchange rate fluctuations, while the latter concerns exchange rate movements over a longer time horizon of six months to a year.

With regard to the issue of short-term volatility, there is some ambiguity as to what the impact of a Tobin tax would be. On one hand, increasing the Tobin tax would raise the cost of transacting and this could reduce volatility. One argument for this is that the Tobin tax imposes a small cost on changing financial positions, and this would discourage random movements of the herd driven by factors unrelated to changes in economic fundamentals. A second argument is that higher costs might reduce the market presence of noise traders by lowering their expected profitability from trading. Though it is also true that some fundamentals investors might also be driven out of the market, to the extent that they change their portfolios less frequently and to the extent that they invest for fundamentals reasons such as diversifying against risk, these investors would be less impacted by a small tax and tend to stay in the market. Consequently, market prices would come to reflect economic fundamentals better. In effect, the Tobin tax would act as a "screening device" that screens out disruptive investors (noise traders) while retaining constructive investors (fundamentals investors).

Balancing these arguments is the possibility that a Tobin tax could increase volatility by reducing the volume of transacting. One point of shared agreement is that a Tobin tax would reduce the "volume" of transactions. However, thin markets (i.e. markets with low transaction volumes) are often associated with large price volatility. This is because opinion tends to move one way in such markets, and diversity of opinion is needed to have both buyers and sellers. In principle, if the Tobin tax were set at too high a level, it could so reduce the volume of transacting that currency markets became thin and volatility increased. However, such an outcome seems implausible given the proposed small magnitude of the tax and given the enormous size of the existing market. Second, what matters for the thinness of markets is the total cost of transacting. Though the Tobin tax would raise marginally the cost of transacting, this cost would still be lower than it used to be owing to innovations in electronic transactions technologies, and the market was not thin in the past when transactions costs were higher. These observations suggest that increased short-term volatility owing to reduced transactions volume (i.e. increased market thinness) is an unlikely outcome.

Whereas there is some theoretical ambiguity regarding the impact of a Tobin tax on short-term volatility, the same cannot be said for medium-term volatility. Exchange rates have tended to be marked by fairly prolonged swings that take them away from sensible values. Such swings are extremely damaging to economies in that they distort the pattern of international production and trade, and this means there is a significant public interest in reducing them. One explanation of these swings is that they are the result of bad domestic economic policy, and in this case the Tobin tax will have little effect. However, another explanation is that exchange rate adjustments tend to under- and over-shoot because of investor behavior. In particular, investors may follow a "momentum" model of buying and selling currencies, so that once a movement gets going it tends to generate an extrapolative dynamic of its own. Eventually the price gets driven so far away from that warranted by economic fundamentals, that the swing reverses. However, in the interim period significant economic damage may be inflicted. It is here that the Tobin tax can help by potentially reducing the frequency and extent of such swings. The economic logic can be understood in terms of the metaphor of a boulder rolling down a hill, with the boulder symbolizing the exchange rate. Once the boulder gets moving, it picks up momentum and is very hard to stop. However, a small wedge (i.e. a Tobin tax) placed under the boulder while still stationary may be sufficient to prevent it from getting started.

The public finance case for a Tobin tax

In addition to preventing speculators from imposing negative externalities on other investors and from increasing market volatility, a Tobin tax also has a public finance justification. It is now widely recognized that a Tobin tax has the potential to raise huge amounts of revenues. Using 1995 currency transactions figures, Felix and Sau (1996, p.238 - 40) estimate the global revenues from a Tobin tax of 0.1% to be between $148 billion and $180 billion. If the tax were set at 0.05%, the revenue estimate is between $90 billion and $97 billion. Using 1997 data, Pollin et al. (1999) consider a joint Tobin - Keynes tax (they call it a Securities Transactions Tax) that applies within just the U.S. to all currency, equity, and bond market transactions. They estimate that this would raise on the order of $70 - 100 billion a year. These enormous revenues could either be retained by national governments to finance important public spending priorities, or they could be used to finance equitable sustainable global economic development - a new global Marshall Plan.

Such revenues appear especially valuable given the widely acknowledged problem of tax competition (Tanzi, 1996; OECD, 2000) which has contributed to an erosion of national tax bases, and to a shifting of tax burdens away from capital on to labor (Rodrik, 1997). In this regard, there is also every reason to believe that a Tobin tax would be relatively progressive in incidence, with the burden falling predominantly on those with higher incomes and on capital.

The amount of revenue raised will also depend importantly on the extent to which the tax reduces currency speculation (i.e. on the elasticity of demand for foreign exchange transactions). If the tax has little impact, the revenues will be relatively larger: if the tax has a large impact, the revenues will be relatively smaller. However, in both cases the tax still remains justified. If the impact is small, this implies the demand for currency transactions is relatively inelastic, and the theory of optimal public finance tells us that governments should tax exactly this type of activity. Conversely, if the impact is large, then speculation will have been reduced, thereby reducing the negative externality imposed by speculators on other investors in accordance with Pigouvian tax theory. This reveals the win - win public finance character of the Tobin tax.

International trade and the Tobin tax An argument that is widely levied against the Tobin tax is that it would tax bona fide currency transactions made to finance international trade in goods and services. This is because the tax cannot distinguish between speculative currency dealings and dealings to finance trade. Since such trade is welfare enhancing, public welfare is reduced to the extent that trade is reduced.

However, there are three counter-arguments to this trade argument. First, the Tobin tax would be very small in magnitude. This means that trade which could not bear the addition of a 1/10 percent tax contained close to negligible social value, and any loss to society would also be correspondingly negligible. In effect, only the most marginal of trade would be displaced.

Moreover, this marginal trade may in reality have negative social value, so that stopping it may be a social good. The reason is that trade often leads to a reallocation of production. This reallocation is decided on the basis of the private benefits and costs to firms, and firms reallocate as long as their net private benefit is positive. Yet, trade induced reallocations of production frequently impose large costs on workers and communities as jobs are lost and worker skills are rendered redundant. These costs are borne by the displaced workers and communities, and are not internalized (i.e. taken account of) in firms' decisions to relocate production. A small Tobin tax would serve as a way of proxying for these costs, and it would force firms to internalize them in their production relocation calculus.

A second reason why a Tobin tax could actually increase trade is that it stands to reduce currency market uncertainty, thereby making it easier for firms to trade. With reduced currency risk, firms would pay less to hedge against foreign currency risk exposures incurred in the course of financing international trade. This would lower the cost of trade, thereby increasing it.

Finally, a third reason why a Tobin tax could increase trade is that the reduction of currency risk that goes with reduced exchange rate volatility could induce firms to substitute away from multi-national production toward increased use of trade. Exchange rate volatility has likely been an important factor explaining the growth of multi-national production. This is because it has given firms a reason to build up a portfolio of production facilities across countries to protect themselves against exchange rate fluctuations. However, in doing so, it has also encouraged firms to reduce their reliance on trade, and instead switch to multi-country production.

Is a Tobin tax feasible?

The theoretical case for a Tobin tax represents but one part of the debate. Equally important is the question of whether a Tobin tax is feasible. Critics claim that it is not. One criticism focuses on "avoidance through jurisdictional shopping", while a second focuses on "avoidance through changed product mix".

With regard to the former, the principal objection to the Tobin tax rests on the claim that it needs to be applied on a global basis in a co-ordinated uniform fashion. Absent this, currency traders will have an incentive to engage in "jurisdictional shopping" and markets will just shift their activities away from countries where the tax is applied to countries where it is not.

Though some jurisdictional shopping would exist in the absence of uniform application, there are a number of reasons to believe that this effect would be inconsequential - especially if the tax were applied amongst a significant groups of countries such as the G-7. This prediction derives from the Bank of International Settlement's (BIS) experience with capital standards which in many regards exactly parallel the Tobin tax. These standards impose an additional cost on banks by asking them to hold more costly equity capital, and banks therefore have an incentive to evade them by shifting to jurisdictions where they are not applied. Yet, there is no evidence that this has occurred. Instead, conforming to the BIS standards has become the equivalent of a seal of good housekeeping, and this has given governments an incentive to apply and enforce them in order to retain good standing and attract business to their financial markets. Despite being subject to the threat of jurisdictional shopping, governments have still managed to join together and make BIS standards the law. This experience illustrates how enforcement of the Tobin tax is a matter of "political will", and that enactment of a Tobin tax by even a few large countries could quickly make it the de facto standard of governance that pulls the rest in.

Furthermore, such a process of establishing a de facto global standard is facilitated by the fact that currency trading is highly concentrated. Using 1995 data, Felix (1996) reports that 62% of trading takes place in the top five markets (U.K., U.S., Japan, Singapore, and Hong Kong) and that 84% takes place in the top 9 (top 5 plus Switzerland, Germany, France, and Australia). If these countries, plus the remaining G-7 countries (Italy and Canada) were to impose a Tobin tax, this would capture the vast bulk of the world's markets.

Not only would it be feasible for the G-7 to go it alone in imposing a Tobin tax, Baker (2000) suggests that the U.S. could successfully unilaterally impose a Tobin tax. The bottom line is that a Tobin tax would fractionally raise the cost of doing business, but the U.S. is one of the world's low cost producers of financial services. Because of this, the small induced increase in the cost of doing business would not necessarily result in much loss of business to other markets. Decisions where to locate dealing do not depend exclusively on narrow transactions costs. They are also influenced by the business environment, the network of other support services and ancillary markets, and the soundness of the regulatory system governing the conduct of business. All of these factors work to the advantage of U.S. markets, so that a small Tobin tax need not be critical in the business location decision.

A second issue regarding feasibility concerns avoidance by change of product mix. Here, the argument is that even if governments were to impose a Tobin tax, market participants would have an incentive to substitute out of financial instruments subject to the tax and into instruments not subject to it. In this fashion, markets would innovate so as to avoid the tax.

There is significant merit to this observation, yet it is ultimately not decisive. First, the extent of avoidance will depend critically on the design of the Tobin tax. To the extent that it is narrowly designed, avoidance will be larger. For instance, focusing on just spot currency markets would clearly induce a huge shifting of transactions into futures and derivatives markets. Thus, the real issue is how to design a tax that takes account of all the methods and margins of substitution that investors have for changing their patterns of activity to avoid the tax. Taking account of these considerations implies a Tobin tax that is bigger in scope, and pushes the design toward a generalized securities transactions tax that resembles the tax suggested by Pollin et al. (1999). There are four benefits to this. First, it is likely to generate significantly greater revenues. Second, it maintains a level playing field across financial markets so that no individual financial instrument is arbitrarily put at a competitive disadvantage versus another. Third, it is likely to enhance domestic financial market stability by discouraging domestic asset speculation. Fourth, to the extent that advanced economies already put too many real resources into financial dealings, it would cut back on this resource use, freeing these resources for other productive uses.

Lastly, there are also significant market forces that deter avoidance behavior. A Tobin tax imposes a small cost on transactors, giving them reason to substitute into different financial instruments. But such substitution is costly both in resource use, and because alternative instruments do not provide exactly the same services. These costs act as a check on the incentive to substitute. Thus, just as the market provides an incentive to avoid a Tobin tax, so too it automatically sets in motion forces that deter excessive avoidance.

The above arguments regarding feasibility are theoretical in character. A final empirical point of support comes from the history of use of transaction taxes in asset markets. Baker (2000) documents how these taxes have been widely used in most major economies, and they continue to be used in many countries. When it comes to domestic asset markets, securities transactions taxes have clearly not prevented the efficient functioning of these markets. The Tobin tax represents a marginal expansion of the domain of these taxes to include currency transactions. Given the history of use of securities transactions taxes, it is hard to see why such an extension would be either dangerously destabilizing or infeasible.

The Tobin tax and the principles of good public policy

Reflection on the issues of enforcement, evasion, and avoidance that surround the Tobin tax raise critical technical questions. But beyond this, such reflection also raises deep issues of principle regarding the purpose and conduct of public policy.

One critical issue concerns the significance of problems of enforcement, avoidance, and evasion in the assessment of tax systems. Critics argue that these problems make the Tobin tax infeasible. The previous section argued that they are likely much less severe than claimed. However, beyond that there is the core point of principle that evasion and avoidance are not decisive in determining whether a tax is warranted. Every tax system is subject to some evasion and avoidance, and the extent of such behaviors is an appropriate concern. But such behaviors are only part of the decision calculus. Also relevant is the amount of needed revenue that the tax raises, and the behaviors it discourages. This is the test that should be applied to the Tobin tax - just as it should for all tax systems - and on this test the Tobin tax scores well.

Beyond this is an even broader principle concerning the nature of regulation in a dynamic global economy. Critics of the Tobin tax argue that financial markets will innovate to avoid it. This is undoubtedly true, yet it does not mean that a Tobin tax is unwarranted. Effective taxation places costs on profit maximizing firms, while effective regulation imposes constraints that prevent them from doing what they would like. Firms therefore have an incentive to search out ways of avoiding taxes and regulations, and over time they inevitably succeed in doing so. Indeed, if the incentive to avoid is not there, it probably means the regulation is of little consequence. Seen from this analytical vantage, it becomes clear that good regulation always sows the seeds of its own destruction. This should be the Rosetta stone of all good regulators.

Over time financial markets will undoubtedly innovate in directions that evade a Tobin tax - as it might be imagined today. But this does not invalidate the case for a Tobin tax. Instead, it affirms the fact that regulation is an on-going process - a dynamic game played between regulators and regulated - that needs to be continually updated. Sometimes regulators manage to get ahead of the game, and other times they just manage to stay even. However, there is never an excuse for capitulating and surrendering the public interest to the dictates of the market. Unfortunately, much of the opposition to a Tobin tax partakes of such a surrender. This is unjustified in principle, and unjustified on the particular merits of the Tobin tax. It is also especially unjustified by the historical moment which has financial markets escaping earlier systems of national regulation, thereby revealing a clear need for new systems of co-ordinated cross-country regulation.


1. Momentum bubbles have a strong resemblance to rational expectations bubbles. The difference is that momentum investors only look ahead one period so that a small tax may be sufficient to prevent them from buying. A rational expectations investor looks into the infinite future, and a small tax may not be sufficient to prevent them from buying if they see future prices rising by a lot. The momentum model, with its truncated investor time horizon, seems a better model of reality. Given this, the Tobin tax could be very effective in preventing bubbles.

2. The economic logic is as follows. Governments need to raise revenues, and hence the need to tax. But taxes change relative prices, thereby distorting the pattern of economic activity and shifting it away from the first best equilibrium that would prevail in the absence of taxes. Public finance theory therefore tells policy makers to tax those activities which are relatively insensitive to increased prices (i.e. in which demand is inelastic) in which case taxes will have relatively little impact on the pattern of economic activity. This is often advanced as an economic justification for sin taxes - taxes on tobacco, alcohol, and gambling - because the demand for sin is relatively inelastic. The Tobin tax can be seen as a form of sin tax - the sin being currency market speculation.

3. This point is made in Palley (1999a).

4. Another consequence of the shift to multi-national production concerns income distribution. By contributing to a changed structure of production, exchange rate volatility has helped change the pattern of bargaining power in favor of capital over labor, which in turn has contributed to a deterioration in income distribution.

5. Baker (2000) makes similar claims about political will comparing the problem of Tobin tax enactment and enforcement to that of money laundering. With regard to the latter, the political will exists to stop it, and governments have therefore joined together to do so.

6. Hirshleifer (1971) provides theoretical arguments why the activities of financial markets may be socially unproductive even though they are productive from a private standpoint. The crux of his argument is that financial markets may engage in activities that are redistributive (my gain = your loss) rather than production augmenting. Tobin (1984) also criticizes the financial system for absorbing to many real resources to the detriment of the rest of the economy.

7. The same market forces also operate to contain the problem of jurisdictional shopping and evasion. Moving the geographic location of transacting is costly in terms of lost business networks, ancillary markets, etc. This dampens the incentive to move.

8. See Palley (1999b, p.110).


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