Destabilizing Speculation and the Case for an International Currency Transactions Tax

Challenge, May, 2001 by Thomas Palley

A second issue regarding feasibility concerns avoidance by change of product mix. Here, the argument is that even if governments were to impose a Tobin tax, market participants would have an incentive to move out of financial instruments subject to the tax and into instruments not subject to it. In this fashion, markets would innovate so as to avoid the tax.

There is significant merit to this observation, yet ultimately it is not decisive. First, the extent of avoidance will depend critically on the design of the Tobin tax. To the extent that it is narrowly designed, avoidance will be greater. For instance, focusing on just spot currency markets would clearly induce a huge shifting of transactions into futures and derivatives markets. Thus, the real issue is how to design a tax that takes into account all the methods and margins of substitution that investors have for changing their patterns of activity to avoid the tax. Taking account of these considerations implies a Tobin tax that is bigger in scope, and pushes the design toward a generalized securities transactions tax that resembles the tax suggested by Pollin et al. (1999). There are four benefits to this approach. First, it is likely to generate significantly greater revenues. Second, it maintains a level playing field across financial markets so that no individual financial instrument is arbitrarily put at a competitive disadvantage versus another. Third, it is likely to enhance domestic financial market stability by discouraging domestic asset speculation. Fourth, to the extent that advanced economies already put too many real resources into financial dealings, it would cut back on this resource use, freeing these resources for other productive uses. [7]

Lastly, there are also significant market forces that deter avoidance behavior. A Tobin tax imposes a small cost on transactors, giving them reason to substitute into different financial instruments. But such substitution is costly in resource use and also because alternative instruments do not provide exactly the same services. These costs act as a check on the incentive to substitute. Thus, just as the market provides an incentive to avoid a Tobin tax, so too does it automatically set in motion forces that deter excessive avoidance. [8]

The above arguments regarding feasibility are theoretical in character. A final empirical point of support comes from the history of use of transaction taxes in asset markets. Baker (2000) documents how these taxes have been widely used in most major economies and continue to be used in many countries. When it comes to domestic asset markets, securities transactions taxes have clearly not prevented the efficient functioning of these markets. The Tobin tax represents a marginal expansion of the domain of these taxes to include currency transactions. Given the history of the use of securities transactions taxes, it is hard to see why such an extension would be either dangerously destabilizing or infeasible.

The Tobin Tax and the Principles of Good Public Policy