Does a Tobin Tax MakeSense?

Neil McCulloch

Sussex Development LectureChichester lecture theatre

11 March 2010

Overview

1. What is a Tobin Tax? The characteristics of financial markets

2. Does a Tobin Tax reduce volatility? In theory Evidence from similar taxes The Inductance Tax

3. Is a Tobin Tax feasible? Substitution Migration

4. How much money will a Tobin Tax raise? and who will pay it?

5. Conclusion

1. What is the Tobin Tax?

“…an international uniform tax on all spot conversion of one currency into another, proportional to the size of

the transaction.”

“A Proposal for international monetary reform”, James Tobin, 1978.

Suggested tax rate: 0.1 %

Main objective: penalizing short-term speculators but not long-term investors, in order to would stabilize markets.

Or perhaps the Keynes Tax?

“Speculators may do no harm as bubbles on the steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation” …

“The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprises in the United States.”

Keynes, J.M. The General Theory of Employment, Interest, and Money. New York, 1936

Characteristics of Financial Markets Excess liquidity (i.e. too much

trading activity) due to the predominance of short-term speculation.

Excess price volatility Long swings in asset prices and

persistent deviations from fundamental equilibria.

Fat tailed distributions of returns and volatility clustering

£/US$ Exchange rate

The much feared Black Swans

Fat tailed distribution

2. Does a Tobin Tax reduce Volatility? Theoretical arguments:

Traditional Approach Heterogeneous Agents Models Zero intelligence Agents Models

Traditional Approach

Traditional theoretical models assume that all actors in financial markets act to maximize their own welfare and that they have “rational expectations” about the future i.e. that people adjust their forecasts to be consistent with their experience so far.

However, such models do not explain many of the characteristics that are observed in real financial markets such as excess liquidity, excess price volatility, fat tailed distributions of returns and volatility clustering.

Heterogeneous Agents Models These models assume that market actors are not perfectly

rational, but rather apply rules-of-thumb when making decisions to buy or sell, based on whatever information they have at their disposal.

They also assume that there are different types of market actors: “fundamentalist” traders i.e. those that trade based on a view

about the fundamental value of the assets, and “noise” traders i.e. speculators.

The volatility of the market is therefore driven by what share of market traders are noise traders (who increase volatility) and what share are fundamentalists (who reduce it).

Zero intelligence Agents Models They assume that market traders in the aggregate, behave

probabilistically rather than being driven by any intelligent maximizing behaviour.

The main assumption is that agents place orders to buy and sell at random, subject to constraints by current prices. They therefore have zero intelligence (although some minimal intelligence is needed for tracking prices). Only the institutions have some kind of intelligence, i.e. auction, which let the prices converge to equilibria.

Gode and Sunder(1993) claim that if students in an economics classroom are replaced in an experiment by zero intelligence agents with a budget constraint, the behavioural results are almost the same.

The Effect of a Tobin Tax on Volatility: Simulation Results

AUTHOR(S) RESULTS

Hanke (2006) Increase or decrease depending on market size

Shi and Xu (2009) Increase or decrease depending on the effect on the number of noise traders

Westerhoff (2003) and Westerhoff and Dieci (2006)

Decrease

Ehrenstein (2002, 2005)

Decrease, as long as the tax rate is not too high to affect the liquidity

Mannaro et al. (2008) Decrease, but only in presence of noise traders in the market

Kaiser et al. (2007) Decrease

Bianconi et al. (2006) Decrease but depending on market size

Volatility and Tobin Tax, THE SWEDISH EXPERIENCE

January 1, 1984 Introduction of a round-trip tax of 1% of the value of exchanged securities (i.e., taxes of 0.5% on both purchases and sales).

July 1, 1986: The tax was increased to 2% 1991, Removed.

THE SWEDISH EXPERIENCE, cont.

These results suggest no significant difference in the weekly variance

However, the daily variance is at its highest level during the 2% tax regime and the difference between the regimes are always statistically significant.

Umlauf (1993) compares the performance of the Swedish stock market under the no tax, 1% and 2% tax regimes.

Swedish shares traded in London are not subject to the tax. If the tax reduced volatility, we would expect the ratio of volatility in shares in London relative to those in Stockholm to increase

Umlauf looks at 11 key shares traded in both countries (e.g. Electrolux, Volvo, Ericsson etc)

Finding: The ratio falls or remains stable across the different tax regimes.

Final conclusion: The imposition and increase of a transaction tax increases volatility in the taxed market.

Daily return standard

deviations

Weekly return standard

deviations

July 1986 to Dec. 1987

July 1986 to Dec. 1987

Number of the ratios that did not rise after the tax increase to 2%

9 5

Average change from the Jan 1984 - July 1986 period

-0,06 -0,02

The Stamp Duty in UK The stamp duty is a tax on “change” in ownership which must be

registered in UK.

Its rate changed over time: 1694: introduction August 1963: lowered from 2% to 1% May 1974: increased from 1% to 2% April 1984: lowered from 2% to 1% October 1986: reduced to 0,5%.

The Stamp Duty in UK effect on Volatility Saporta and Kan (1997) compare the performance of the UK

stock market before and after the announcement of an increase or decrease of the Stamp duty.

Moreover, they compare the price of a sample underlying shares of UK-listed companies, (subject to stamp duty), with the price of their US-listed American Depositary Receipt (ADR) (not subject to stamp duty).

Hypothesis: similarly to Umlauf (1993), if the ratio ADR/UK diminishes with the increase of tax, it would suggest that transaction taxes increase volatilities.

Findings no significant effect of UK Stamp duty imposition on volatility of

equity prices. Not much variation of volatility across stamp duty regimes.

Inductance tax The existence of spikes in a distribution caused by manias and panics

reflects the presence of high frequency components in the time series. Engineers routinely remove undesired high frequency elements using “low-

pass filters”. The resistance of the inductor is proportional to the rate of change of the

current going through it – when the frequency is changing slowly resistance is minimal and the current passes through but when the frequency is high the current is blocked.

A tax with the same property as an electronic inductor would help to prevent spikes.

Inductance tax : Don’t tax trade, tax panic An inductance tax would tax transactions at a rate proportional to

the rate of change of the aggregate market price. (Note that this is quite different from a Tobin Tax which would charge a fixed small tax rate).

With an inductance tax, sales and purchases would incur virtually no tax during normal times because the aggregate market movement is very small. But during crashes sales would face heavy penalties, as would purchases during booms.

Because market participants would know that they would face heavy taxation associated with buying during booms and selling during panics, they would be discouraged from making these trades thereby lessening the mania or panic.

Volatility: Conclusion Financial markets are very volatile. There are periods of more volatility and periods of

less In theory, a Tobin like tax could reduce volatility But existing theoretical and empirical evidence do

not give a clear picture of the effect of a Tobin Tax on volatility

This may be because the underlying assumption (noise traders are bad) is wrong.

If so, an Inductance Tax might be more stabilising than a Tobin tax.

3. Is the Tobin Tax feasible?The Tobin like tax “could be implemented relatively easily and cheaply, using existing market infrastructure and networks” (Kapoor, 2006)

Three challenges to implementation

1. At what point in the system to levy the tax?

2. What instruments to tax?

3. How do you avoid migration to untaxed locations?

Structure of the Foreign Exchange market

FOREIGN EXCHANGE

MARKET

REPORTING DEALERS

43%

OTHER FINANCIAL INSTITUTIONS

40%

NON FINANCIAL CUSTOMERS

17%

mutual funds, pension funds, hedge funds,

currency funds, money market funds,

building societies, leasing companies, insurance

companies, other financial subsidiaries of corporate firms and central banks

smaller commercial banks and

securities houses

non-financial end users, such as corporates and governments.

INTERBANK -WHOLESALE

MARKETRETAIL MARKET

Large commercial and investment

banks; large securities houses

At what point in the system to levy the tax?

There are thousands of dealers and intermediaries across many countries …but the same is true of retailers in countries who still

manage to charge sales tax/VAT However one might be able to levy at settlement

The Continuous Linked Settlement Bank (CLS Bank) settles 55% of global foreign exchange transactions (rest through High Value Domestic Settlement systems of individual countries)

More than 60% of all sterling and euro transactions are settled in the CLS system. The majority of the remainder processed through the UK’s CHAPS and the ECB’s TARGET System for their respective currencies.

A single clearing system, SWIFT and its affilitates, is used for all large-value financial transactions, allowing tracking of transactions

What instruments to tax? Foreign exchange spot? Forwards?

Futures? Options? Swaps? All derivatives?

They have dramatically different costs so you would have to tax at different rates (RHT propose 0.005% for forex and for bond and derivative markets; and 0.5% for equity)

Financial markets are extremely innovative!

This imposes a cost on tax authorities keeping up with avoidance

But (almost) all foreign exchange contracts end in a spot transaction

How do you avoid migration to untaxed locations?

Migration risk is real Almost 60% of the trading volume of the 11 most actively

traded Swedish shares migrated to London because of the Swedish tax!)

Long-run effects are larger than short-run effects Shifts in institutional capacity and expertise take time.

But

Avoidance is harder than it used to be New centres have higher settlement risk (HERSTATT Risk) They must follow Basel II rules and comply with money

laundering regulations which is expensive

Bottom line on ImplementationIdeally

Get everyone in the world to agree! Impose penalties on non-compliant states

In practice if you tax immobile resources …and the big

players complied then can still raise revenue The UK’s Stamp Duty still raises £3,203 million

each year (2008-09, National statistics, HM Treasury and Custom, September 2009).

4. How much money will a Tobin Tax raise? It depends on one’s assumptions about:

Tax rate Reductions in trade Avoidance Scope of application

Author(s) Tax rate

Year of Daily

turnoverGeographical

coverage ElasticityReduction of volume

Total Annual Revenue ($ bn)

Tobin 0,50% 1995 Worldwide 1500Spahn (1995) 0,02% 1995 Worldwide none 50Felix and Sau (1996) 0,25% 1995 Worldwide

0,5% to 1% 300.2 to 393.4

Frankel(1996) 0,10% 1995 Worldwide 0,32% 166

Spahn (2002) 0,10% 2001

EU and Switzerland

(including the UK) none 15% 16

UN (General Assembly, 2001) 0.1% 2001 Worldwide 132

Paul and Walhberg (2002) 0,05% 2001

Worldwide but no US$ and other major currencies none 50% 38

Bruno Jetin and Lieven Denys (2006) 0,10% 2004 Worldwide 1% 67% 125Spratt (2006) 0,005% 2005 UK (sterling) 0.11% 5% 3

Schmidt (2008) 0,005% 2007

Only dollar, Pound, Euro

and Yen 0.43% 33.41

Who pays the bill?

5. Conclusions The idea of a Tobin Tax is a good one – financial

markets are excessively volatile, so there could be strong gains from greater stability

The evidence that a Tobin Tax would reduce volatility is weak … an Inductance Tax might do better

Implementing a Tobin Tax would be difficult … but not impossible

A Tobin Tax would raise significant revenue … but a lot less than its advocates claim

It seems likely that a significant share of the cost would be passed on eventually … but the revenue collected and any additional stability gained might still make it worth it