Arguments for and against Tobin Tax - Coursework Example

Arguments For and Against Tobin Tax

Introduction

Professor James Tobin a lecturer at the University of Princeton and one of the US Nobel Prize winner in economics in 1972, made the first proposal for tax transactions that involved the conversion of one currency to another. He then advanced the ideology in his Presidential Address to the Eastern Economic Association in 1978 that consequently was published in the Eastern Economic Journal (vol 2). This is what became to be known as the Tobin Tax and has consistently featured in the political scenes.

The Tobin tax was to be charged on the foreign exchange transaction at a uniform, but low, ad valorem rate (Yates 2009). The professor himself suggested the rate of 0.2%, 0.5%, and 1% while leaders afterward like the French Prime Minister in 1995 proposed 0.1%. Tobin argued that if the transaction were as a result of the long-term investment, the levy would amount to an insignificant extra cost to the entire project. However, for the operation on short-term speculation that occurs due to the shifts in a particular currency, it resulted in significant levies that increased the risk of loss to foreign exchange. The tax would, therefore, have three primary functions to the exchange: reducing exchange-rate volatility by reducing currency speculation, raising revenue for international organizations and making national economic policies less vulnerable to external shocks (Brassett 2010).

Reducing exchange-rate volatility

There is always speculation in a foreign exchange market since countries use different currencies and the appropriate way to impede this, is to have a common currency in the market. However, in the absence of world currency like in EU, countries can adopt various ways to ensure efficiency including special deposit requirement for the financial organizations, taxes and direct control on the conversion of currencies and the movement of capital (Brassett 2010). But critiques have divergent opinions on these measures. For instance, free movement of capital is considered advantageous to an economy and action to limit it may throw out the benefits of productive investment and certain operations as hedging that aids in the growth of trade and stability with the aim to destabilize speculation (Dowling 2004). Second, unilateral measures as well are more damaging to the exchange rate than they solve the problem. Therefore, taxes can be easily avoided while rigid controls put a nation off from the economic reality as it will continuously lose their competitiveness. The Tobin Tax would help eliminate the problem by creating an international agreement with the leading financial institutions. For example, the risk of a country opting out may be reduced by introducing a condition that allows for access into the IMF.

Revenue-raising

Tobin assumed that even if half reduced the current foreign exchange that 20% of the tax was being evaded, and another 20% were exempted, a 0.1% of a Tobin Tax is likely to raise $50 billion in revenue annually (Erdoğdu and Balseven 2006). This figure is more than double the amount spent on development programs, stabilization of the economies, UN activities, and peace-keeping missions. He then argued that less developed countries keep their entire revenue they collect in taxation while excess funds will be available to major financial institutions that can be used for development and stabilization globally.

Reducing vulnerability to external shocks

The capability of the national economies to conduct monetary and economic policies on a clear basis of domestic procedures on an international scale is limited to the action of free movement of capital within the nations. For example, the interest rate is high than those set by internal monetary conditions due to the speculative pressure on the foreign exchange rate damaging the economic growth and employment to a country. A Tobin Tax would, therefore, reduce the exchange rate volatility, and speculation that could spur growth in many economies since exposure to international financial markets and exchange rates puts pressure on national governments to follow the inflationary policies (Erturk 2002).

Discussions in the European Parliament

The Monetary Affairs Subcommittee of the European Parliament held an in-depth discussion regarding the Tobin Tax and other related issues on the same on 1993. The public hearings as well considered other contributions from experts that were subsequently published by the Directorate for General Research in the Economic Series Paper of 1994. From the paper, a tax was considered as two probable ways to prevent speculation. Further, the purchasers of the foreign currency against the local currency were required to place a certain proportion of the buyers’ non-interest bearing deposits into the relevant bank (Erturk 2006). The latter criterion has had an experience, unlike the Tobin Tax. For instance, the Spanish government successfully used the non-interest bearing during the economic crisis of 1992.

The analysts sharply criticized the use of tax or individual deposits since they viewed it as a way to the reintroduction of the control capital movements. Haberer (2003) argued that it inhibited the development of financial markets that was the significant share of the European developed countries GDP and hence, was a backward on the realization of the Single Market. Other experts though were less critical to the restrictions on the capital movement. They proposed the use of Tobin Tax to seek the practical problems that had a significant influence to the broad conclusion who agreed that stronger international cooperation in the financial and economic field was of the essence (McCulloch and Pacillo 2011). They argued that stability of the global economy would be enhanced by international cooperation by creating a global tax system, comprehensive supervision framework, global monetary system, and world trade rationalization agreement. In this concept, it was indispensable that a Tobin Tax became feasible.

How the Tobin Tax works

Assume a speculator who anticipates the increase in the Dollar against the Euro. The gambler decides to enter into a contract of selling and buying the currency. For instance, if he sells say one thousand Euros for a week, the speculator would receive $ 1100. But suppose over the week the Dollar rose to equivalent with the Euro, he would resell the $1100 for 1100 Euros and in the process get a profit of 100 Euros representing 10% profit. Nonetheless, the speculator incurs some standard tax that would barely deter the speculation. The Tobin Tax, however, is deducted from the gross sum involved. He would pay 5 Euros for at a rate of 0.5% when making Dollar purchases and a further 5.5 Euros while reselling. Summing the total tax would be 10.5 Euros that translates into 1.05% on the profit obtained. But this again would be a nondeterrence to the speculator.

But suppose the fluctuation of the currency did not occur, i.e. the Dollar parity was constant the entire period, and then the speculator still pays the Tobin Tax. In this regard, he pays 5 Euros while making Dollar purchase and $ 10 on the resell representing a levy of 1% in the capital. Therefore regardless the market situations say the Euro appreciating against the Dollar, the Tobin Tax would still be paid despite the loss in the speculation.

Estimate of a Tobin Tax revenue

The expected amount that was to be raised by a Tobin Tax depends on numerous factors. they include the extent to which the tax achieved the desired effect of reducing short-term speculation, the rate of the tax, the amount of non-conforming financial centers and non-taxable transactions and the extent to which specific transactions were exempted (Mende and Menkhoff 2003). Various calculations were therefore made based on the worldwide figure for foreign exchange transactions of $1 trillion a day. For example, David Felix, an Economist in 1995 assumed that 20% of operations would be exempted from tax while a further 20% would evade it. Finally, while noting that the actual percentage vary with the rate, he assumed a 50% would fall in trading volume due a tax rate at 0.5% or 1%. Based on similar assumptions, Rodney Schmidt argued that at a tax rate of 0.1%, $700 billion in revenue would be yielded in a trading day. The estimate total revenue of Rodney on an annual basis, therefore, came to $54 billion a year.

Beneficiaries of the Tobin Tax

The principle objective of the Tobin Tax was not only to deter speculation in the European Market but also to resolve other economic issues. The Tobin Tax had the potential to generate revenue during high demand, and funding was becoming incredibly impossible to finance international public programs. The first program was to fund the UN and its agencies in humanitarian and peacekeeping missions. Second was to bring order into the trading systems and international finance. For instance, the United Nations annual budget and its entire agencies as the World Bank were approximate $18billion with $2.5biilion in arrears and $1.8 billion on peace missions. A substantial proportion of the Tobin Tax would hence provide a huge boost to the organization funding.

Professor Tobin then proposed that the revenue collected of any Tobin Tax to be paid to the World Bank or IMF. He advocated for the revenue to be shared between the international programs and the collecting authorities and should use the progressive method to split the revenue (Nissanke 2003). Fewer development nations should then keep most or all of their collection so that they do not undermine the system when they do participate. This means that international programs were to be financed by vast financial powers.

Arguments For and Against the Tobin Tax

From the discussions above, the primary purpose of the Tobin Tax was to reduce exchange –volatility by controlling speculation. A 0.1% and 1% tax rate was expected to discourage speculation in the short term exchange transaction and only influencing actual investment marginally.

The deterrent effect

The application of a small tax on the short-term exchange transactions deters speculation. According to Rajan (2001) while revisiting the Tobin Tax observed that a 1% of the tax on each of the week “round trip” speculation sums to an annual tax rate of more than 100%. This does not, however, imply a loss to the speculator since if the parity of the conventional currency operations fell by more than 2% during the trading week, there is still the gain from the transaction. The trader is, therefore, less concerned with the annual rate.

The Tobin Tax eliminates speculation when small parity shifts are involved. This is because the inter-bank operations that require low margins are positively affected. However, the tax is unlikely to have any effect on the substantial market positions that occur as a result of the major currency mayhem. For instance, the events of the Brazil real in 1999, a tax of 0.1% or 1% is inconsequential compared to the expected parity changes. Brassett (2010) examined this point into detailed. He observed that a 1% tax on a round trip might lead to a compound annual rate of 180% over the week. But suppose the market forecast indicated 4% devaluation of the currency, with a 0.5% probability at the end of the week, and then the anticipated gain from the currency would be a 2% that represents an increase on an annual basis. Tobin Tax proponents, therefore, concede that the tax has a little deterrent effect on speculation especially if the market is fundamentally misaligned to the parities.

The promoters’ admission also led to a concession that the instability experienced in foreign exchange market is not due to the immoral speculators as the governments and Central Banks leads to the building of the misalignments (Haberer 2003). For example, in 1992, the events and effects of German reunification resulted in re-alignment parities that were inevitable. The authorities were, therefore, unable to have it in an orderly manner but the markets would. The operations of the events were not reactive but only determined the timing when the Pounds would fall, but in the process, it fell further than the expected (Bianconi, Galla, Marsili and Pin 2009). In this regard, the speculation increased exchange –rate volatility. The same occurred in 1993 when Sterling was undervalued due to market overshoot and never recovered to the levels expected for few years. The question is therefore if the Tobin Tax would have made a difference even with a 1% tax rate? The Tobin Tax critiques hence argue that instead of the tax-reducing volatility it increases it leading to the market position taken.

The effect on beneficial transactions

Tobin Tax assumed that it had a slight marginal effect on the valid non-speculative trading. To this ideology, it is true especially in the long-term investments where a 1% Tobin Tax leads to 0.2% when annualized in a period of 10 years holding that capital is repatriated. It is because speculators are not merely drawn into day-trippers and plans for the longer stay. For instance, a direct investor in any country is usually the most severe traders in the capital markets.

Other analysts have as well drawn attention to the challenge of separating destabilizing from stabilizing operations. During the periods of massive realignments, a Tobin Tax does have a little effect on the speculation and hence would deter bets on small exchange rate changes (Mende and Menkhoff 2003). Nonetheless, a high percentage of such transactions have insurance as their principle focus. In this case, a Tobin Tax would deter speculation but at the expense of high costs of standard goods and services. This is because trading institutions would transfer the cost of the Tobin Tax as they will widen their spreads making the market thinner, expensive and the short run rates being more volatile (Erturk 2006). As such, it is debatable whether a Tobin Tax as initially advocated would reduce or increase exchange rate volatility: this is certain for the short run.

To mitigate the risks, stabilize the transactions and deter speculation, there was an attempt to use a two-tier Tobin Tax. First was a permanent tax deal that levies low rate percentages on the foreign exchange operations and the other half the level rates on the derivative trades say 0.1%. The second applied solely to the speculative trading? Further, another two-tier Tobin Tax was proposed where a 0.1% would be charged in average times and then adjusted to 1% to 10% during in a financial crisis (Yates 2009.)

The two-tier Tobin Tax was though powerfully criticized as it was deemed unattainable and having negligible side effects. It is because the core operations of a tax not necessarily reduce exchange rate volatility while variable levy rates would lead to uncertainty in the market (Mende and Menkhoff 2003). Furthermore, it is almost impractical to find for a standard two derivative to establish the tax system that yields the same tax equivalences.

The tax as revenue-raiser

A single idea of the Tobin Tax was irrefutable since even at the lowest tax rates with a sharp decline in foreign exchange operations, the system was able to raise a high volume of money. As such the issue of distribution and redistribution was to be discussed into detailed. Assume that the proceeds collected by national governments were to be retained; the impact would be a shift for the nations to have a significant financial center to the rich countries around the world. This is unacceptable since it leads to inequitable distribution. In this case, the various procedure of redistribution was advanced, and the most notable one is the Tobin Tax plan. Tobin proposed the allocation of revenues to the international organizations as IMF and World Bank to revolutionize the purpose of the international institutions (Patomäki 2001).

The income collected and retained by the national governments as well can be used to change the national tax systems. Specifically, the amount received due to a Tobin Tax allows for the shifts to capital taxation from the labor taxation that is in line with the current principle purpose of the taxation system policy within the European Union (McCulloch and Pacillo 2011).

However, it remains a concern whether the national governments can make the tremendous sacrifices of fiscal independence that involves the Tobin own proposal. Of the proposed international financial institutions: IMF and World Bank, neither currently enjoys popularity with the nations (Nissanke 2003). To make matters worse, the international community does not seem willing to dedicate a proportion of the income to be involved in the development aid and to assist in stabilization.

But in reality, there is no doubt that a Tobin Tax results in new costs of operations in the financial market that is transferred to the consumers. But again an increase in the tax burden is never popular with the users (Dowling 2004).

There are also considerable challenges with the revenue proposal by Tobin. The awareness that exists is a significant amount of funds for the financial bailouts leads to a moral hazard both with the public authorities and in the markets (Nissanke 2003). The speculators in the financial market will hence take greater risks while governments would be involved in massive debts and even stand the armed conflicts in the anticipation that the UN peace-keepers would finally arrive (McCulloch and Pacillo 2011).

Again, the revenue collection and distribution through the Tobin Tax process result in the risk of both the official corruption and private sector (Haberer 2003). This necessitates the need to have a complex and rigorous international auditing system. Unfortunately, even the European Union itself is not yet completely off the hook to this challenge

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The tax as "fiscal buffer"

Another major argument in support of the Tobin Tax is that it makes national macroeconomic policies less susceptible to exchange –rate pressure. In effect, this is the result of the deterrent of the speculators.

In foreign currency markets, currencies are always under pressure, but the authorities do have numerous defensive measures at their disposals. The central bank can intervene by defending the parity of the currency. But the success of this depends on upon the amount of standby credits that can be called upon, size of the foreign exchange reserve available to the country and the perception of the authorities to be firm (Mende and Menkhoff 2003)

Another defensive measure is to increase the short-term interest rates. For the successful operation of this in the market, the interest rate increase should be able to offset any expected fall in the exchange rate; and for any likely fall, the countermeasures can always be high. If the market is to stabilize, the annualized percentage rate in either tens or thousands is of the essence. Such slight shifts in interest rates over the short time are dangerous to the internal economy. They result in a bad monetary contraction that has a longer effect on growth, investment and employment (Rajan 2001). It is estimated that challenges of this nature come about due to attempts to defend unlikely parity. Either the policies or internal fiscal measures must be adjusted or allowed to float.

The floating of the exchange rates as well is not costless. Nonetheless, they are not susceptible to massive speculative positions since they can be subjected to both the short term and long term volatility (Avitable 2002). As was the case with the Sterling in 1992, the increase of the costs of hedging against the exchange risk destroyed the competitive position of the traders. Hence, the interest rate is not solely determined by the desire for currency stabilization but must consider the effects on the exchange rate. The increase for the benefit rates for internal controls leads to an appreciation in the currency that reduces competition of exporters. Therefore, to the degree of the Tobin Tax reduction of the exchange rate pressures (Bassett 2010. it improves the ability of the national governments to focus on the control of their national economies.

Unfortunately, an economist Goodhart challenged the assumption of the fiscal buffer proposition. He argues that there is no evidence to the impact of interest rates on exchange rates. Within a freely floating system, the interest rates are so significant that the national monetary autonomy is severely precluded (Dowling 2004). Furthermore, a particular national economy in market assessment is revealed as a whole during the reactions in a foreign exchange market. The effect of the national economies insulation is that the governments who hold the real domestic interest rates low at the expense of the worse potential future inflation.

But in his critique, he overlooked one major significance consideration. The Democratic politicians’ listens to the public opinions as expressed in the ballot box. While, the economist have numerous optimal solutions that are never put into practice. Hence, in academic standards, the significance of the market forces in establishing the economic policies is a fundamental concern in any political philosophy (Patomäki 2001). Therefore, the fact that Tobin Tax increases the voters chances of making wrong choices does not imply.

Practicality

The last argument for and against Tobin Tax is the degree of its practicability: say how easy is it to collector evade the tax. This depends on whether the tax could be collected or applied uniformly to the international transactions. For efficient operations, ways will have to be formulated to deter the foreign exchange asylum.

Essential concern is a simplicity to which the tax base can be evaded as trading changed into the cash-substitute market. For instance, if the tax was to be levied solely when converting the Dollars into Yen and vice-versa, then trading will immediately change into the US and Japanese three-day Treasury bonds. If taxation were applied to these operations, the trade would be shifted into the commodity market. Assume, for instance; a contract denominated in Dollars against the contracts in Yen. An extension of taxation system into these markets could make speculators move into changing the financial instruments (Haberer 2003). Hence, levying the tax under conditions would become uncertain. Under this circumstance, there is likelihood that the single payers of the Tobin Tax are the ordinary traders operating the goods and service markets while the speculators would evade.

The successful operation of the Tobin Tax is therefore only possible if it is integrated to be part of the reforms in the international monetary system including an outline for the financial markets supervision by the global authorities (Rajan 2001). Such favorable agreements include the conclusion arrived at in 1993 by the European Parliament Subcommittee on Monetary Affairs hearing.

Conclusion

Regardless of the arguments for and against the Tobin Tax, it is of the essence to be understood clearly the ideology is just but an option. For instance, in the European Single Market, the possible solutions to the volatility in the exchange rate have never been based on tax currency conversion and any suggestion will rarely see the end of the day. As such the best solution is a long term development of the international medium of exchange, perhaps the $ currency.

Tobin Tax though is useful as the source of revenue to international organizations and for policy formulation since it has colossal attractions. Since the international agencies are experiencing a shortage in funding to offer essential services like health care, education, refugee programs among others, the flat rate tax as a result of the Tobin would help a grand deal.

However, purely as a solution to the exchange rate volatility, the response is a thumb down. It is because the international supervision and the simplicity to evade the tax is a concern if the tax is ever sufficient. Economists like Professor Goodhart powerfully argue that a free floating exchange rate is not a full answer to the volatility but only limits potential speculation. Finally, the discussion that a Tobin Tax aids governments to maneuver in managing the macroeconomic policies are for debate since matters of economic policies depends on the politics and academic scholars.

In conclusion, the feasibility of a Tobin Tax depends greatly on the economic and technical factors rather than international degree of political developments. The exploration of the global financial design to reduce the risk to some of the disrupting impacts on free capital movement is now on. In this regard, the Tobin Tax has found other proponents such as the market-oriented approach to manage speculation as a result of currency volatility. Therefore, if a decision is made to re-introduce, controls on capital investment that are imposed unilaterally and little by little, the Tobin Tax is a perfect alternative.