by Justin Cash

Countercyclical policy is a tricky business.  Recession governments have pushed round after round of stimulus package and quantitative easing.  But in the continual search for an economic panacea, the idea of a financial transactions tax has been gaining force.  First proposed by Nobel Prize winning economist James Tobin, his formulation of such a tax was originally one that would cover all spot conversions of one currency into another.  His intention was mainly to penalize short-term financial round-trip excursions into another currency.

Current financial troubles are evidently not limited to foreign exchange markets though.  For this reason, many are calling for a more general transactions tax on the dealings of financial institutions, levied on dealings in shares, bonds and derivatives.  The furor surrounding this idea may not be misplaced.  Primarily such a tax may act as a stabilizing force, slowing down flows of hot money that potentially contribute to financial volatility.  This volatility critically impacts upon the investor and consumer confidence that is conspicuously waning of late and is desperately needed.  The hope is that this will also constrain the riskiest and most speculative of trades, making traders think twice about each deal they wish to conduct.  If we are genuinely concerned with the risks our financial institutions are taking, as we appear to be, then reducing high frequency trading may at the very least kick start measures to wean them off gambles.

Back in 2001, Tobin suggested a fairly arbitrary rate of 0.5% of transaction volume.  Many agree that this would be approximately optimal.  However, it is easy to spot the trap that one falls into when setting the effective tax level.  Either the level is so low that it is entirely ineffective, or it is so high that it inhibits liquidity in the financial system too much.  Conducting empirical analyses should help clear up some of these uncertainties.  There is an argument for preferring the rate to be at a conservative, low level, perhaps even below Tobin’s suggested 0.5%.  This follows the work of Spahn (1995) who argues: “If the tax is generally applied at high rates, it will severely impair financial operations and create international liquidity problems, especially if derivatives are taxed as well.  A lower tax rate would reduce the negative impact on financial markets…” There appears to be little that is objectionable in this.

Even if the levy is ineffective at providing stability, governments may still draw significant revenue from a highly profitable sector.  A recent European Commission report suggests that a Tobin style tax within Europe could raise €57bn (approximately £49bn) annually, which could either boost the EU budget or end up in the coffers of national treasuries.

Opponents of such measures will insist that our financial institutions and some of our finest minds will relocate if they were introduced.  There is much truth in these claims.  In an increasingly globalized economy, the so-called ‘brain drain’ is a clear and present danger, and not just an empty threat.  Asian economies would be more than happy to accept major banks that are interested in moving base, for example, alongside the inevitable increase in trade on their markets.  For this reason, unilateral implication of a Tobin style tax amounts to economic suicide.  The key is to somehow achieve a truly global implementation of the policy.

If nowhere else, there is at least potential for the Eurozone to form an effective consensus.  This is evidence by the deals struck to form bailout packages for its ailing economies.  But at meetings on the 8^th of November in Brussels, the Netherlands, Sweden, Italy and several other EU members all demonstrated their support of British Chancellor George Osborne’s staunchly anti Tobin-tax stance.  Many fear that this spells the end for any such measure.  Combined with worries that implementation of a tax on financial transactions would drive up borrowing costs and irreparably damage some institutions, many are still skeptical of such a measure.  It certainly seems that, regardless of its merits, a Tobin-style tax on our financial institutions is a very remote possibility at present.