A tax on forex transactions may prove a godsend to the finance minister, should the sanctions force him to have a supplementary budget, say Swaminathan S Anklesaria Aiyar
The Asian currency crisis has revived interest in the Tobin tax, a small tax on all foreign currency transactions proposed by Nobel Laureate James Tobin in the 1970s.
Daily trading in foreign currency now exceeds $1.3 trillion, more than the foreign exchange reserves of all countries put together. Short-term currency movements, driven by euphoria or panic, can drown long-term fundamentals and cause financial stampedes in and out of countries like Mexico in 1994-95 and Asia last year. Tobin tax aims to ‘throw sand in the wheels’ of currency markets, in order to achieve four things.
- The most important in today’s context is that the tax will discourage volatile short-term transactions while leaving long-term ones almost untouched. Four-fifths of foreign exchange transactions involve round trips of 7 days or less: most occur within a day. A Tobin tax of 0.2 per cent will add up to 48 per cent if a transaction is repeated every working day of a year, 10 per cent if repeated every week, 2.4 per cent if repeated every month. But it is a trivial charge on long-term investment. Thus it will encourage desirable long-term flows at the expense of volatile short-term ones.
- Replacing non-tariff barriers by tariffs increases economic rationality and efficiency. Many developing countries have capital controls today, and are tempted to tight on them after the Asian debacle. If instead are replaced by a Tobin tax, that could increase efficiency.
- Currency volatility can seriously affect a country’s monetary and fiscal autonomy. By reducing volatility, a Tobin tax could increase government freedom of action.
- It could yield very large revenues. If imposed globally, a tax of 0.1 per cent could fetch $148 billion-$168 billion. This could solve the fiscal problem of several countries, and finance multilateral agencies like the World Bank and IMF.
Seventeen economists have discussed the pros and cons of the Tobin tax in a recent book (The Tobin Tax; Coping With Financial Volatility, Eds Mahbub ul Haq, Inge Kaul and Isabelle Grunberg, OUP 1996). Free-marketeers oppose a Tobin tax on the ground that anything which increases transactions costs is economically inefficient. They say the tax will simply damage liquidity without ending currency runs or reducing volatility. Indeed, it might even increase volatility by driving out stabilising contrarian speculators. Such critics believe the right solution is for countries to reform faulty policies, not tax transactions.
But other economists believe financial markets are imperfect and often overshoot, and a Tobin tax could counter this. Jeffrey Frankel (University of California, Berkeley) uses survey data to show that short-term investors tend to extrapolate current trends (increasing volatility), while long-term investors expect current movements to be reversed, and so lend stability to exchange rates. The debate continues, but the Asian crisis has strengthened those sceptical of market perfection, especially in short-term trades.
How much policy autonomy will such a tax give governments? Very little. A Tobin tax of 0.2 per cent, equal to 48 per cent if a trade is repeated daily for a year, is far too small to deter speculators who scent an overnight devaluation of 1 per cent (equal to an annual change of 365 per cent). Hong Kong had to impose short-term interest rates of over 300 per cent to ward off speculators last year. At most, a Tobin tax could provide a little breathing space.
Will such a tax be enforceable? If any one country imposes a Tobin tax, transactions in its currency can simply move offshore. So to be workable, the tax needs to be imposed by all countries with significant markets—Even then completely new financial markets could come up in remote Pacific or Caribbean tax-havens. The cost of creating new markets is substantial, yet Singapore and Hong Kong have done so successfully in the last two decades.
To avoid the migration of transactions, Tobin says the tax should be universal, and the simplest way to achieve this is for the IMF to make this tax a condition of membership. As a carrot, all countries except those with major financial markets could keep the tax they collect. The big markets have the lion’s share of transactions and will get the lion’s share of revenue, and could be asked to hand over a significant percentage of this to the World Bank, IMF, Global Environment Facility or other such multilateral agencies.
Taxing spot transactions in foreign currency will not be enough. Speculators will seek to evade the tax by shifting to forwards, swaps and derivatives. They could also shift from trading in currency to mutual exchanges of treasury bills and other money-substitutes. A lucrative market will crop up for financial engineers who will constantly devise new instruments that mimic currency trades. Governments will have to be alert and extend the tax to new money-substitutes as and when they appear, and this will be administratively cumbersome. Optimists reckon that a tax of, say, 5 basis points will be too small to attract financial engineers. Pessimists say even a tiny percentage of a trillion-dollar market is a huge incentive for evasion.
Frankel points out that today’s trading is mainly between dealers; only one in five transactions is with outsiders. The margins on inter-dealer trades are too thin to tolerate a Tobin tax. Exemption could be given for trades between dealers, but that would open a tax loophole. A better way out, says Tobin, could be to tax only the net daily position of traders.
A Tobin tax will endanger today’s decentralised dealer-driven system, where a single order from a retail investor may lead to three to ten trades within the dealer community to disperse their individual risk. The tax will encourage a shift to computerised, screen-based trading systems that link principals while cutting out dealers. Trading volume will crash. A screen-based system will be more centralised than a dealer-based one. Some economists are suspicious of centralisation, but it will cut transactions costs.
While opinion remains divided on the economic merits of the Tobin tax, the main problem it faces is political. Getting all countries to unite on any issue is difficult: it will be especially difficult on an issue which financial markets across the globe are likely to oppose.
The greatest attraction of the tax, from the viewpoint of politicians, is its ability to raise huge revenues without touching the common man. This revenue will enable right-wingers to cut direct tax rates and left-wingers to increase public spending. Countries with large unfunded pensions or fiscal deficits will find it a godsend. Thus a tax originally designed to stem currency volatility might ultimately prove acceptable because it serves the private agenda of so many decision-makers.
In India, it would serve another private agenda — the BJP ideology of swadeshi. The Swadeshi Jagaran Manch has not thought about it, but will surely love a tax that falls on dollar transactions but not rupee ones. The chances of rupee transactions migrating to other centres is limited because of our capital controls, so a modest tax could fetch useful money at a time when the fiscal deficit needs reining in.
So if indeed western economic sanctions force Mr Yashwant Sinha to have a supplementary budget, do not be surprised to see a tax on foreign exchange transactions. It will not, of course, be called a Tobin tax (this would be too videshi for Mr Sinha’s liking). Let it be called a Hedgewar tax, or a Deendayal Upadhyaya tax. They would have approved, I am sure.