Lord Turner and the Tobin Tax

Otmar Issing, former chief economist of the European Central Bank, once said, “The Tobin tax will come back consistently like the Loch Ness monster.” In fact, here it is again, right in time for the G20 summit!

What is new this time is that the proposal to tax financial transactions doesn’t come from an academic.

Rather, a practitioner of high reputation has lent it his support. It is none other than the Chairman of the Financial Services Authority (FSA) in London, Lord Adair Turner. This may explain why the finance industry is particularly infuriated this time.

The idea of taxing financial transactions is ascribed to Yale professor and Nobel laureate James Tobin. He proposed the tax to “throw sand in the wheels” of foreign exchange transactions in order to reduce the scope for speculative transactions.

Tobin thought this could reduce exchange rate volatility and stabilize international financial markets. For Tobin, the tax was hence purely regulatory. Its revenue-collecting function was not its main purpose.

Lord Turner’s suggestion and the Tobin tax are, in fact, distinct animals — although they both aim at taxing financial transactions. Tobin was satisfied to tax foreign exchange transactions only. Lord Turner appears to advocate for a much broader tax on global financial transactions, which have supposedly become inflated and “useless” from a socio-economic point of view.

What they have in common, however, is that they would be the first truly “global taxes.” This would require cooperation at a supra-national level, with all its political intricacies.

Who would legislate and govern the tax? Who would collect the tax? How should the tax revenues be distributed? What global policies should be financed through the tax, and how?

We may come to the point where political leaders and parliaments could indeed reach agreements on a global tax to finance global objectives and policies (for instance, in view of climatic change), but such proposals still need time to ripen.

What can we say on the feasibility of a financial transactions tax? For the Tobin tax, with its limited scope, the answer is straightforward: The structure and processes of modern foreign exchange markets would render it relatively easy to levy such a tax. Here is why:

• Worldwide, by far the largest part of wholesale foreign exchange dealings is channeled through only one bank (the CLS bank). That is because the technology used to control counterparty risks (the Herstatt risk) has natural monopoly characteristics.

• Transactions are carried out through automated systems, so it would be easy to insert a small software routine for administering the tax. Compliance costs would tend to converge toward zero.

• The transaction volumes in foreign exchange markets are immense: $3.2 billion daily (in 2007), of which $1 billion is in the form of spot transactions. Hence, a microscopic tax rate could levy substantial revenues without encroaching noticeably on trading decisions.

• The tax could be levied at settlement with the central bank. This would exclude a significant number of transactions from tax (netting and OTC operations) or tax them only partially (financial derivatives), but it would render the tax extremely transparent and simple to administer. This, together with the fact that foreign exchange transactions are time-critical and market participants usually shun counterparty risks, would counteract tax evasion through re-routing.

In such a framework, the Tobin tax would become akin to a fee for service, or an insurance premium. The central bank of the currency area would be in charge of collecting the tax. There is no need for cooperating at the global level because the tax could be levied upon only one leg of the transaction.

For instance, the member governments of the eurozone could impose the tax unilaterally, while settlement of the paired currency would remain tax-free. Evasion is impossible as long as the euro is part of the deal, but it would be desirable to extend the tax regime onto other important currencies traded within the same time zone (British pound, Swiss franc) to avoid re-routing through substitute vehicle currencies.

Technically the tax would either increase the bank’s seigniorage — or nurture a specific purpose account for financing global policies. This requires fundamental agreement on the key political questions of a global tax, which have been addressed above.

Once this is decided, market participants are likely to treat the tax as costs, which are ultimately shifted onto longer-term investors such as insurance companies or investment funds.

It should be clear, however, that the rate of the Tobin tax would have to be calibrated in microscopic proportions of the transaction value to preserve liquidity in the market.

This renders it totally unsuitable to counteract speculative trading in foreign exchange markets, which was Tobin’s very objective.

Regulatory taxation to stabilize exchange rates could, however, be combined with the Tobin tax through a supplementary surcharge, which would remain dormant for trading within a normal price corridor, but would start biting increasingly when trading is effected outside the corridor.

Despite its clear advantages as to viability and technical feasibility, the Tobin tax remains an unloved child by both market participants and politicians alike. Its time has not yet come, mainly because of the horrendous political uproar such a global tax would raise. What, then, are the chances of a tax on a broader set of global financial transactions as suggested by Lord Turner?

First, the liquidity function of world financial markets cannot be overemphasized. The recent financial crisis has vividly demonstrated the importance of liquidity risks, so a tax that would impede liquidity trading would be counterproductive.

Second, not all liquidity trading is “useful” from an economic point of view. So Lord Turner has a compelling point indeed. For instance, so-called “flash” trading is a computer-based technique aimed at skimming off possible arbitrage gains just a fraction of a second earlier than a potential competitor.

It is hard to make a case for this kind of trade other than voraciousness. It is economically sterile, and socially inequitable.

Nevertheless, it will be extremely difficult, if not impossible, to distinguish between normal liquidity trading and inflated, useless financial transactions. Even if this were possible, it would be extremely hard to tax comprehensively in a highly fragmented global market, and to assess the various complex forms of financial transactions it generates.

This would only be possible where markets tend toward natural monopoly, or centralization, such as the foreign exchange market or stock exchanges. Where market organization relies on institutions facilitating financial trading (such as the central bank or the exchanges), levying the tax is much simpler.

This is because it is difficult to avoid, and it would easily be perceived as a fee for service. A tax levied at financial trading desks will always be shunned by relocating desks to places outside the tax jurisdiction.

While the scene for a Tobin tax is likely to evolve, the scope for a Turner tax remains extremely limited — both technically and politically. Moreover, it would neither induce stability in global financial markets nor prevent future crises (like the pure Tobin tax without supplementary surcharge).

Whatever multiple causes the present financial crises may have, ultimately, they boil down to excessive lending and the neglect of counterparty risks. It explains the breakdown of liquidity markets and the need to adopt concessional monetary policies.

None of these problems would have been avoided by a tax on financial transactions. But central banks, instead of rewarding overnight deposits of commercial banks, could have employed negative interest rates, which is tantamount to a tax. At least it would have helped to redress the interbank liquidity market.

Lord Turner is chairman of a supervisory institution, and his suggestion to tax financial transactions is but one of the many proposals discussed among supervisors.

In my view, it is more beneficial to focus on supervisory instruments (which still have to go global!) in order to forestall future financial crises.

In addition to bolstering the capital base of lending institutions and the inclusion of non-bank financial agents such as hedge funds, there is desperate need for better accounting rules, in particular the appropriate valuation and inclusion of counterparty and liquidity risks in balance sheets.

This way we are likely to guard against future crises much better than through an inefficient and inoperational Turner tax.