——— FINANCIAL POLICY FORUM ———
DERIVATIVES STUDY CENTER
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TRANSACTIONS TAXES, OR
THE TOBIN TAX
Financial Policy Forum
Transactions taxes, briefly stated, are small tax rates applied to transactions in foreign currency and possibly also to transactions in securities, derivatives and other financial instruments.
The argument in support of the transactions tax proposal is as follows. One premise is that a large of transactions, especially in foreign currency markets, are conducted by a “speculator” and the consequence of their activity is to generate greater volatility in exchange rates. Alternatively, foreign exchange markets are used by speculators as a necessary step in their cross-border speculation in developing countries – leading to what is called “hot money” – and this causes greater volatility in developing financial markets.
Based on this premise, the imposition of a transactions tax will raise the cost of speculation and in turn lower the volume of transactions. In turn, this reduced trading volume will reduce the volatility in prices of the instrument or instruments being traded. Internationally it will reduce the volume and volatility of capital flows – especially those to developing countries – that begin with or otherwise require transactions in foreign currency. Furthermore, the reduced volume of transactions will discourage speculative attacks on fixed exchange rate regimes and enhance the ability of central banks to maintain or defend regimes.
In addition to the reduction in price and flow volatility, another important benefit of the transaction tax would be to raise substantial amounts of revenue that could potentially be directed towards financing additional foreign aid or investment in developing countries. Even with the imposition of a small tax rate and a substantial reduction in trading volume, the remaining volume would potentially raise a large amount of revenue that is estimated in the hundreds of billions of U.S. dollars.
The idea is most closely associated with the late Nobel laureate for economics, James Tobin, and is often referred to as a Tobin Tax. As he described it in Tobin (1978), “my proposal is to throw some sand in the wheels of our excessively efficient international money markets.” His primary motivation for the policy, however, was not to reduce volatility or finance development, but rather to enhance the effectiveness of monetary and fiscal policy. The “efficiency” of capital mobility was otherwise diminishing the effectiveness of those policies, especially monetary policy whose impact occurred largely through its effect on exchange rates and their impact on the trade balance.
However the idea can be traced back to at least 1936 when Keynes wrote in The General Theory about his opposition to the distortions of speculators in financial markets.
“The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the dominance of speculation over enterprise in the United States.”
Keynes’ views towards speculation were most likely formed prior to the passage of Securities Act of 1933 and the Securities Exchange Act 1934. That legislation introduced reporting requirements to financial markets in the U.S., which changed market fundamentals by providing for greater market transparency and thereby the basis for informed investing instead of that based on rumor and hearsay. Even though Keynes visited New York City in the summer of 1934, it is most likely that the effect of this new legislation did not attract his attention, and neither the legislation nor its consequences were mentioned in the General Theory, the first draft of which was completed in late 1934.
The idea was more recently picked up and pursued by such notable economists as Larry Summers, who was later to become U.S. Treasury Secretary, and Joseph Stiglitz who was to become Chair of the Council of Economics Advisors and Nobel Laureate. Summers has since changed his view. Whereas Keynes had based his argument on a “behavioralist” approach to financial markets, Summers and others based theirs on a “noise trader” model of financial markets.
The transactions tax rates most usually proposed as remedies to volatile international financial transactions range between 0.05% and 0.25% of principal. Although the rate is small, it would amount to a very large proportional increase in current transactions costs because the bid/ask spreads in the interdealer market are between one and four ten-thousands of principal (0.01%-0.04% or 1-to-4 pips).
Transactions taxes already exist to a small and limited extent in the U.S. They are technically treated as "fees" and are applied to transactions in publicly traded securities and exchange traded futures and options. The long standing transactions fee for securities of 1/300 of 1% – 0.0033% – raised $1,090 million in FY2000. On January 16, 2002, President Bush signed into law H.R.1088 that lowered securities transaction fees to 1/883 of 1% – 0.0012% or $12 per $1,000,000 – of the value of the transaction in securities. The fee is collected by the Self-Regulatory Organizations – namely the New York Stock Exchange and National Association of Securities Dealers – and goes to cover the cost of the Securities and Exchange Commission.
A somewhat similar fee is charged on the public trading of futures and options on behalf of customers (non-exchange members). Such public trading amounts to 23% of the total trading volume on U.S. futures exchanges. The fee is charged by the National Futures Association in order to cover is operating costs. The fee was recently lowered on April 1, 2002 to $0.10 on round-trip trades in futures and $0.05 in options (those fees are scheduled to be reduced to $0.08 and $0.04, respectively). It is not a tax or a fee required by federal statute, but rather a fee imposed by the NFA based on its authority as a Congressionally authorized Self-Regulatory Organization.
Both the securities and exchange-traded derivatives fees (or taxes) are very, very small – far less than one basis point or 1/10,000 or principal or notional principal. They are in fact so small that their existence should not bear significantly on the debate because they have no apparent effect on impeding transactions volume in U.S. equity and futures markets where volume is the highest in the world. They are mentioned merely to recognize them as a precedent in highly liquid financial markets. And as a precedent, it is worth noting that the derivatives transaction fee is not assessed on transactions between exchange members, i.e. on the core, liquidity trades in the market.
The goals, or intended benefits, of transactions taxes include the following:
1. Reduce the volume of foreign exchange (and possibly other) transactions, and thereby reduce the volatility of foreign exchange rates (and possibly other prices).
2. Reduce the returns to short-term speculation.
3. Reduce the amount of speculation and the incidents of speculative attacks on currency regimes.
4. Reduce the volume of speculative flows of “hot money” and other short-term investments.
5. Reduce the volatility of international capital flows and the price volatility in markets for foreign exchange and related financial instruments.
6. Encourage long-term relative to short-term investment.
7. Raise substantial revenues for development and other purposes.
These goals are highly laudable, and they help explain why there are so many supporters of this proposal. However, there are also problems with the proposal. They include the tremendous political challenge of raising a uniform tax around the world, the feasibility of administering the collection and distribution of the tax, and more fundamentally whether the premise for the policy is correct and thus whether the policy would in fact be effective in achieving its claims.
Political problems include:
1. Requires worldwide agreement and coordination. Many countries must join in order to avoid substantial leakages. The rise and rapid growth of the Eurodollar market is an indication of the volume of transactions that can occur outside a system of central bank members. And size of assets deposited in off-shore tax havens is another indication of the potential to move trading activity outside the Euro-Yen-Dollar realm of regulation.
2. The free-rider problem. Any effort to arrange such a tax treaty will have to overcome the incentives for free riders to refuse participation or to cheat once they agree to join. Enforcement efforts will have to overcome greed and ingenuity.
3. The are powerful vested interests that have not yet begun to oppose transaction taxes of any sort.
4. There is a very powerful, if not overwhelming, opposition to any tax increase in the United States, and without the U.S. the proposal could not be successful.
5. Most of the revenue will be collected by the wealthy countries. More than half of trading occurs in the London and New York, and 84% of spot trading involves U.S. dollars. It will be difficult to direct those revenues raised in those locations against the dollar or other major currencies towards developing countries or development purposes.
Administrative and enforcement problems include:
1. Enforcing the tax across national boundaries.
2. Enforcing the tax across other markets. A transactions tax will need to apply to a wide array of financial instruments, especially derivatives, in order to prevent substitution.
3. Recording keeping for all foreign exchange (or other) transactions across national boundaries and thus across national jurisdictions.
4. Enforcing distribution of tax revenue.
Uncertain policy outcome problems include:
1. It is likely to reduce liquidity, but unlikely to reduce volatility.
2. Reducing liquidity will possibly increase volatility.
3. It will not prevent speculation based on the likelihood of large changes in prices, i.e. speculative attacks on fixed exchange rate regimes.
4. It will not seriously discourage "hot money" flows or the carry trade (interest rate arbitrage).
5. It will not make foreign debt repayment any easier, and will likely make it more expensive.
6. It will further advance the U.S. dollar as the world currency. It will create incentives to further dollarize the developing world in order to save on transactions costs.
The are better policy tools than transactions taxes with which to address policy targets without generating unwanted collateral problems. Prudential regulations of financial markets, for example, will discourage, and to some extent limit, speculation, without reducing liquidity or raising volatility.
Transactions taxes create disincentives to trade, and this disincentive is especially strong for liquidity trading (which accounts for a large share of transactions in most financial markets). In contrast, prudential regulations can create limits and disincentives for holding large open positions – i.e. actually taking on the speculative positions – whereas transactions taxes raise the cost of building a speculative position by no more than trading for liquidity or for trade or long-turn investment.
Transactions taxes do not prevent, or for that matter even substantially discourage, speculative attacks or speculation in anticipation of a major currency devaluation. Even transactions tax proponents such as Tom Palley (2001, p. 74) admit to this short-coming. Prudential regulations would directly address this speculation in several ways, and it would do so in a way that would not make markets less liquid. And in so far that financial markets become less liquid, then they are more susceptible to manipulation or more prone to speculative attacks.
An alternative tax policy that would more directly discourage short-term speculation would be the imposition of a capital gains tax – one that might tax gains on short-term investments at a significantly higher rate than long-term investments – that would reduce the returns from both short-term noise trading and the speculative attacks that arise at the moment fixed exchange rate systems come close to crisis. Oddly, such a tax already exists in the U.S., but is absent in Europe where support for transaction taxes is higher. Its application and enforcement mechanism could be expanded and strengthened so that the compliance rate increased for international transactions. The extension of the tax internationally could be accomplished one country at a time, and the extension to the European Union and Japan could be justified in the name of tax equity or a level playing field.
Whereas transactions taxes would curtail so-called “noise trading,” i.e. trading that might be otherwise described as intra-day speculation and inter-dealer liquidity trading, this is not the source of a major public policy problem. Even if noise trading were the cause of moment-to-moment or day-to-day volatility, it is not this high frequency volatility that is of substantial consequence to the macro economy and the public interest. Rather it is the greater magnitudes of volatility that occur over a longer horizon (or lower frequency). Arguments that noise trading is essential for “trend investing,” which pays-off over the term of the trend, is inconsistent with the assumption of short-term round-trip noise trading. In comparison, prudential regulations would discourage excess speculation on both short-term fluctuations and longer-term trends.
“Hot money” or excessive capital flows in the form of short-term bank credits, could better be discouraged by prudential regulation. Transaction taxes, even at the higher end of most proposals of a 25-basis points, would not substantially discourage developing countries from borrowing in dollars -- or U.S. banks from lending in dollars – when the interest rate differential is in the range of 500 to 1,200 basis points. Consider an example in which a 90-day foreign currency loan is advanced and repaid four times in a year. Assume each advance and repayment involved a foreign exchange transaction that is taxed at the 25-basis point rate. The eight transactions would add roughly 200-basis points to the cost of the investment. This disincentive may not be decisive spreads in excess of 500-basis points. More likely, the act of rolling-over loan would not require a foreign exchange transaction at the start and end of each loan. In this event, the tax would be applied only at the beginning and end of the year, at total of 50-basis points. This more plausible scenario suggests that the tax would be a small disincentive in comparison to potential spread from carry lending. In contrast, capital requirements that limit currency exposure would more directly discourage such excess borrowing and lending.
Automatic circuit breakers. One variant of the transaction tax, designed by Paul Bernd Spahn (1995, 1996), proposes a two-tiered transaction tax that would apply a very low tax rate during period of market normalcy (defined by an exchange rate band) and a very high tax rate that would be triggered by a surge in market volatility (defined by a movement beyond the band). Although Spahn is not supportive of the currency transaction tax as proposed by Tobin, which he states would “impair financial operations and create international liquidity problems,” he thinks the two-tiered tax would solve these problems. He proposes applying a very small transactions tax rate, between zero and one basis point, to currency transactions that occur when the exchange rate is within a band that is set according to acceptable level of volatility. This would avoid impairing liquidity when trading is within the accessible range of volatility (although this means that it would not curtail the “noise trading” that is maligned by most transaction tax proponents). If the exchange rate moves beyond that band, meaning that volatility has increased beyond the acceptable level, then a substantially higher transactions tax would apply to the transaction (the higher tax rate would apply to the amount in excess of the band so that the effective tax cost would rise as the exchange rate moved further beyond the band).
This is an interesting innovation on the transactions tax proposal. It solves one problem by not impairing liquidity but it creates another. Investors are likely to accelerate their reactions to large movements in the exchange rate because they do not want to wait and get hit with a punitive tax. Faced with the threat of a high tax rate, investors will have incentives to sell as the exchange rate depreciates towards the band (or buy as it appreciates towards the band). The consequence of this incentive will be to increase the rate of selling (or buying, respectively) and not discourage it. Thus the Spahn proposal might in fact act as a crisis accelerator by inciting an early rush to sell (or buy) prior to the imposition of the higher tax rate.
In contrast, there are a couple of prudential regulations that have proven to be effective in the U.S. at curtailing disruptive or potentially explosive price movements in the market. They vary between futures and securities markets, but they all involve price limits or “circuit breakers” that trigger a temporary or day-long cessation of trading or at least computer program trading. These have long been a feature of futures exchanges, and they were introduced to U.S. securities markets in the wake of the stock market crash in October of 1987.
Of course, prudential regulations will not raise tax revenue for development or any other purpose. If transactions taxes are viewed as a means of raising tax revenues, then it certainly is a potentially large tax base. Yet alternative tax policies, such as the capital gains tax, would not have the potential to impair the orderly functioning of financial markets.
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 ) A few good summaries of the proposal include: Tobin (1978), Palley (1999), and Pollin, et al (2001).
 ) The premise has been criticized on a theoretical level by Randall Dodd (2002), Paul Davidson (1997, 1998), and on an empirical level by Habermeier and Kirilenko (2001) amongst others.
 ) There might need to be some experimentation with the tax rate in order to get the desired effect.
 ) The original paper was his 1972 lecture that was published as Tobin (1974), but a more readily available explanation can be found in Tobin’s Presidential Address to the Eastern Economics Association and published as Tobin (1978).
 ) Keynes (1936, p. 160)
 ) Sir Harrod (1951) states that “By the end of 1934 the first draft of the The General Theory of Employment, Interest and Money was complete.”
 ) See Summers (1990) and Stiglitz (1989).
 ) The fee was introduced in Section 31 of the 1934 Securities Exchange Act, and they are known as Section 31 fees on transactions.
 ) See CRS reports by Jickling (2002) and Kiefer (1990).
 ) According to the National Futures Association, 2002.
 ) Foreign exchange is normally quoted in ten-thousandths of a dollar ($0.0001) or a unit of some other currency. The term “pip” is often used to mean the last digit in the price (expressed in ten-thousandths) or some say a “principle interest point” which is equal to one ten-thousandth. In much of the literature on the transaction tax, the term basis point is used to refer to this ten-thousandth (0.0001 = 0.01%).
 ) It should be kept in mind that price limits are not intended to solve long-term problems or those based on major changes in market fundamentals, but are instead designed to prevent brief or very rapid price changes from creating problems in and of themselves.