What's Wrong With the "Tobin Tax" Revival?
Click here for a print friendly version of this article.
Last week, a new heavyweight international task force met in Paris to discuss proposals to impose an international “Tobin tax” on financial transactions. The idea for such a tax was floated by French President Nicholas Sarkozy in September and then embraced by the Chairman of the United Kingdom’s Financial Services Authority (FSA), Adair Turner. And on October 19, Brazil began imposing a version of the tax, levying a two percent tax on foreign portfolio investments. While a “Tobin tax” is unlikely to earn the support of many European Union countries, let alone nations throughout the world, the idea has piqued the interest of those looking for punitive measures to impose on bailed-out financial institutions. And it has influential supporters in the United States. Nobel Laureate economist Joseph Stiglitz has spoken favorably of the idea, and White House economic adviser Larry Summers endorsed it in a 1989 journal article.
The original “Tobin tax” was proposed by Nobel Laureate James Tobin in 1978 as a way of segmenting national economies and throwing “sand in the gears” of the financial system. He argued that cross-border capital flows were destabilizing and deprived governments of short-run autonomy. To deter such transactions, Tobin recommended the imposition of a uniform tax rate on all spot conversions of one currency into another. This uniform tax would, said Tobin, deter “hot” speculative flows because the effective cost of a fixed rate tax on investment is inversely proportional to the length of the holding period. The table below provides an example of the returns required to offset the cost of the tax for a range of holding periods (all rates of return are annualized). With a 5% domestic interest rate and a 0.1% Tobin tax, a five-year foreign investment would only have to earn 5.04% to provide an equivalent return – a very slight deterrent. But the Tobin tax would impose prohibitive costs on short-term bridge financing, and investments seeking to arbitrage away temporary mispricings.
The “new” Tobin tax under consideration would impose the same flat rate on all financial transactions. Instead of deterring investors from acquiring assets denominated in a foreign currency, this new tax seeks to deter investors from altering the composition of their portfolios. Most investors would be effectively “locked in” to current positions because the cost of rebalancing would far exceed its prospective benefits in most situations.
The Tobin tax raises a number of problems. For starters, it would choke off liquidity in many asset markets, as investors needing to sell holdings would have to entice prospective bidders with large discounts to compensate for the tax. Ironically, this would increase the pro-cyclicality already endemic to asset markets, as sellers in down markets would have to offer even bigger discounts to sell. Therefore, any gains that come from reduced volatility would likely be more than offset by lower asset prices, on average.
Second, the tax would also curtail daily trading, and thus undermine price discovery functions and arbitrage activities (defined as a mispricing between a security and an equivalent portfolio). Although trading is often blamed for sparking greater volatility in asset prices, it also imparts valuable information about perceptions and risk aversion that may moderate overall price moves. If frequent, daily price changes are replaced by larger price moves or jumps, the lower overall volume could lead to higher annualized price volatility.
Third, the tax would have a minimal impact on strategies that are dependent on larger, destabilizing moves in asset values. While legitimate efforts to balance one’s portfolio and erase temporary mispricing would be severely penalized, strategies that depend on high-impact, low probability events would be relatively unaffected by the tax. Put another way, the returns generated by a small arbitrage opportunity would not be sufficient to offset the tax, but the returns generated by "big moves" would more than suffice. So the tax would discourage helpful transactions to correct temporary mispricing, but do nothing to diminish the attractiveness of bets on destabilizing price jumps in asset prices.
Finally, the tax would be nearly impossible to enforce. Although the U.S. already imposes a “tax” on every stock transaction through Section 31 or “SEC” fees, these fees are currently set at $25.70 per million dollars of principal. And the fees are designed to fund the operations of the Securities and Exchange Commission (SEC), not to deter “excessive” trading. If these fees were increased to a punitive level, it is likely that investors would simply move to derivatives markets. And that would likely accelerate the growth of the structured notes market where financial engineers could structure products to produce a range of cash flows to match investor liquidity and risk preferences. The effect would be to curtail transparency and increase volatility – the very problem the Tobin tax is supposed to solve.
The desire to punish bailed-out banks and their managers is understandable, given the severity of the contraction caused by the financial meltdown. However, a newfangled Tobin tax on all financial transactions is likely to create a new set of problems that surpass prospective benefits.