FRBSF Economic Letter
99-12; April 9, 1999
 Economic
Letter Index
Time for a Tobin Tax?
On a typical day in the foreign exchange market roughly $1.5 trillion
changes hands. This means that in less than a week foreign exchange transactions
have exceeded the annual value of world trade. Not surprisingly
then, surveys find that actual "users" of foreign exchange are involved
in only one out of every five trades. The rest are trades among the dealers
themselves. Furthermore, surveys suggest that more than 40% of all transactions
involve round trips of fewer than three days!
The explosion of foreign exchange trading has coincided with a string
of spectacular currency crises: first in Europe, during the summers of
1992 and 1993, next in Mexico at the end of 1994, then in Southeast Asia
during the summer of 1997, then in Russia during the summer of 1998, and
most recently in Brazil, in January 1999. A growing chorus of critics
have drawn a connection between these currency crises and the frenetic
activity taking place in the foreign exchange market and have called for
measures to "throw sand in the wheels of the foreign exchange market,"
in order to reduce destabilizing speculation and improve macroeconomic
performance.
Some have gone beyond talking. On September 1, 1998, Malaysia announced
that it was imposing a range of capital controls designed to prevent foreign
investors from taking their money out of the country (at least without
paying a stiff penalty). These restrictions enabled the Malaysian central
bank to cut interest rates without having to fear a run on its currency.
It's too soon to say what the long-term consequences of these controls
will be, but the relatively favorable performance of the Malaysian economy
since they were imposed has certainly caught the eye of its distressed
neighbors.
This Letter will provide a broad overview of the pros and cons
of capital controls. Because capital controls come in so many different
flavors, it is impossible to discuss them all in any detail. Generally
speaking, capital controls are distinguished by intent (keeping money
out vs. keeping money in), by type of transaction (gross purchases and
sales vs. net position-taking), and by type of asset (stocks, bonds, bank
deposits, derivatives, etc.). To maintain a narrow and manageable focus,
this Letter just evaluates the merits of one particular proposal
that has attracted the attention of the economics profession, largely
because its original proponent is a widely respected Nobel prize-winning
economist.
What is a Tobin tax?
In 1978, James Tobin proposed a worldwide tax on all foreign exchange
transactions. Tobin justified the tax on two grounds. First, he argued
that it would reduce exchange rate volatility and improve macroeconomic
performance. Second, he argued that the tax could bring in a lot of revenue
to support international development efforts.
The defining characteristic of a Tobin tax is that it would be a tax
on gross transactions; that is, the tax is paid twice, once when
you acquire foreign exchange, and again when you sell the foreign exchange.
Double taxation at a fixed rate has the crucial consequence of discriminating
automatically against short-term capital flows. For example, suppose a
0.1% tax is levied on all foreign exchange transactions, and that the
(annualized) domestic interest rate is 5.0%. Then, with a one-year holding
period, the interest rate on a comparable foreign currency denominated
asset would have to be at least 5.2% to make foreign investment attractive.
If instead the foreign asset is held for only a month then the foreign
interest rate must be at least 7.4% to offset the tax. For one-day round
trips foreign rates would have to be at least 77%! Thus, a small and enforceable
Tobin tax could virtually shut off short-term capital flows.
Discrimination against short-term capital flows is not a feature shared
by many popular forms of capital controls. For example, reserve requirements,
often used to inhibit capital inflows, do not in general discriminate
in favor of long-term investments. Often these are just taxes on net position-taking,
in which banks must deposit some portion of their net external liabilities
with the central bank at zero interest. However, it is possible to make
the deposits temporary, which would discriminate against short-term
flows. For example, beginning in 1991, Chile has required banks to maintain
a reserve requirement against external liabilities, but these reserves
only had to be maintained for periods ranging from 90 days to a year.
Initially, the requirement was set at 20%. It was then increased to 30%
in 1992, where it remained until 1998, when it was removed in response
to the international financial crisis. Many have argued that temporary
reserve requirements were effective at keeping "hot money" out of Chile,
without unduly hindering long-term investment.
Still, the speculative disincentives of a temporary reserve requirement
are modest relative to the Tobin tax. Indeed, if your goal is to limit
short-term capital flows, it is hard to beat a Tobin tax. The real questions
are whether in fact it is desirable to limit short-term capital flows
and whether in practice a Tobin tax would be enforceable.
Is a Tobin tax desirable?
No one doubts the potential benefits of international capital mobility.
Open capital markets give savers a higher rate of return while simultaneously
lowering the cost of capital for borrowers. Open capital markets also
deliver diversification benefits, allowing investors to obtain the same
returns on their risky portfolios with less risk. However, these benefits
are predicated on the efficient functioning of markets, and many have
argued that the foreign exchange market in particular is subject to distortions
that may justify government intervention.
The most commonly cited inefficiency in the foreign exchange market is
the reputed tendency of currency traders to engage in destabilizing speculation.
Unfortunately, establishing that speculation is destabilizing is not so
easy. It certainly doesn't follow simply from the observed volatility
of exchange rates, since the determinants of exchange rates (like monetary
and fiscal policies) could themselves be volatile. In fact, Friedman (1953)
famously argued that speculation couldn't possibly be destabilizing, since
that would imply speculators were buying high and selling low. Speculators
who do that go out of business.
The fact is, it is impossible to tell whether speculation is destabilizing
without first distinguishing "speculative" trades from other trades, and
second, without having a reliable model of exchange rate determination
that tells you how exchange rates would behave in the absence of speculation.
That is, one needs a counterfactual against which observed volatility
can be compared. Sadly, economists do not currently possess such a model.
Without it, debates about excess volatility are like debates about the
existence of life on other planets.
A second argument for throwing sand in the wheels of the foreign exchange
market is related to government policy. All governments, either implicitly
or explicitly, stand behind their banking systems. If a sufficiently large
bank or a sufficiently large number of banks gets into trouble, governments
find it politically impossible to stand on the sidelines and watch banks
go under. Since bankers know this, there is some tendency for banks to
take on too much risk. Although this is a problem that would exist even
in a closed economy, it becomes especially severe in open economies, since
currency speculation (e.g., unhedged foreign currency liabilities) is
an easy way to exploit government guarantees. A Tobin tax could mitigate
this problem by raising the cost of foreign currency speculation.
Finally, a third market imperfection used to justify government intervention
is the notion that foreign exchange markets suffer from "multiple equilibria,"
i.e., a given configuration of monetary and fiscal policies may be consistent
with more than one value of the exchange rate. If this is the case, seemingly
insignificant events can trigger dramatic swings in the exchange rate,
as the market switches from one equilibrium to another. Proponents of
this argument claim that policies like a Tobin tax, which slow down the
foreign exchange market, can eliminate the multiple equilibria and thereby
stabilize the economy.
Theories of multiple equilibria are based on the concept of self-fulfilling
beliefs, i.e., that speculators base their investment decisions on beliefs
about the future which their own (collective) decisions bring about. (This
idea provides a counter-argument to Friedman's contention that destabilizing
speculators must lose money.) Perhaps the most persuasive example was
put forth by Obstfeld (1986). He showed that when government policies
themselves react to the exchange rate, then speculators' beliefs can elicit
government responses that justify those beliefs. This view of exchange
rate determination is in marked contrast to traditional views, which typically
assume government policies are formulated independently of the exchange
rate.
While each of these arguments can justify a Tobin tax, each has its limitations.
Dellas and Stockman (1993), for example, point out that the multiple equilibria
story cuts both ways. They show that beliefs about the imposition of capital
controls can be self-fulfilling. That is, if speculators believe the government
will try to lock the doors during a crisis, this will simply precipitate
a dash for the exits, as each investor tries to get out while the doors
are still open. If the government could commit not to resort
to capital controls, investors might have the confidence to stay in when
the going gets tough. Similarly, while a Tobin tax might help offset moral
hazard problems in the banking sector, it is probably a poor substitute
for direct policies of prudential regulation and supervision.
Would a Tobin tax be effective and enforceable?
Despite the theoretical ambiguities, many have argued that a Tobin tax
suffers from two fatal pragmatic flaws. First, the tax must be
unreasonably high to achieve what many regard as its primary goal, namely,
preventing speculative attacks against fixed exchange rates. Second, a
Tobin tax is not likely to be enforceable.
Earlier it was argued that a modest 0.1% tax would require huge interest
differentials to justify one-day bets on exchange rates. However, this
kind of calculation is misleading in the context of speculative attacks
against pegged exchange rates, since it ignores the fact that anticipated
annualized gains can themselves be quite large. For example, a 10% devaluation
on a single day translates into an annualized return of over
300% for short-sellers. So even if speculators assign relatively low probabilities
to such events on any given day, it may still be worthwhile to make the
bet. In other words, Tobin taxes would do little to extend the lives of
unsustainable currency regimes.
Enforceability is the real Achilles' heel of the Tobin tax. There are
two distinct issues. First, since transactions in the foreign exchange
market take place around the world, a Tobin tax would require global
cooperation. Otherwise, foreign exchange business could gravitate quickly
to any country that did not enforce the tax. Moreover, attracting this
business is desirable. Currency trading is a highly paid job and would
yield spillover benefits to other businesses. Tobin argued that cooperation
might be enforced by allowing local governments to keep the tax revenue,
but this would simply shift the problem to the size of the tax rather
than enforcement per se.
The second enforceability problem relates to the definition of the tax
base. That is, how exactly is a foreign exchange transaction to be defined?
Modern financial engineering is based on replicating one asset with combinations
of other assets. At a minimum, the tax would have to be applied to forward,
futures, and swap transactions in addition to spot transactions, since
a spot transaction can be replicated easily by a combination of debt and
forwards, futures, or swaps. In fact, the problem is even worse than this.
Spot transactions could also be approximated by exchanging liquid securities
(like T-Bills) denominated in different currencies. Consequently, the
tax would likely spread and eventually come to envelop large segments
of what is traditionally regarded as the domestic capital market. This
problem, more than any other, would likely kill the Tobin tax.
Conclusion
Whether a Tobin tax is desirable depends on your beliefs about the efficiency
of the foreign exchange market. Economic research has not yet resolved
this question. While this leaves the door open to advocates of a Tobin
tax, most experts believe that it suffers from severe pragmatic flaws,
primarily due to enforcement problems. Consequently, recent discussions
of capital controls have shifted to unilaterally enforceable policies,
like Chilean-style reserve requirements. Assessing the costs and benefits
of these policies is an active topic of current research.
Kenneth Kasa
Senior Economist
References
Dellas, Harris, and Alan Stockman. 1993. "Self-Fulfilling Expectations,
Speculative Attack, and Capital Controls." Journal of Money, Credit,
and Banking 25, pp. 721-730.
Friedman, Milton. 1953. "A Case for Flexible Exchange Rates." In Essays
in Positive Economics. Chicago: Univ. of Chicago Press.
Obstfeld, Maurice. 1986. "Rational and Self-Fulfilling Balance of Payments
Crises." American Economic Review 76, pp. 72-81.
Tobin, James. 1978. "A Proposal for International Monetary Reform." Eastern
Economic Journal 4, pp. 153-159.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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