Tuesday, July 10, 2012

The Tobin Tax Anathema

Europe's lurch left will amplify calls for a tax on financial transactions. Its populous is
hungry for redistribution, stability and social justice. Francois Hollande believes a socalled
Tobin tax will bring stability and raise revenues to fund infrastructure. A
commitment to include such a measure in any EU budgetary renegotiation helped
him win the presidency. In Britain the tax has received the theological backing of the
Archbishop of St Andrews, and a recent poll by Oxfam finds 51% of the public
support the idea. Though the aim is laudable the approach is flawed.

In 1971 President Nixon divorced the dollar from gold, thereby ending the Bretton
Woods system. The ensuing instability in currency values caused by the ‘Nixon
Shock’ led James Tobin, professor at Princeton and student of Keynes, to call for a
tax on currency transactions, to throw ‘sand in the wheels’ as he put it. These days
the term ‘Tobin Tax’ is used as a catchall for financial transactions taxes.

Its enduring appeal comes from a ‘double dividend’ argument. Proponents say that a
‘small’ tax on every financial transaction would bring stability and raise revenues.
There is however an inherent contradiction in this argument as the objectives require
opposing behavioural responses. To raise revenue you want low responsiveness and
to create stability you want high. Responsiveness, or elasticity, depends on the rate
at which the tax is levied. Presently the European Commission is proposing rate of
0.1%, which it hopes will raise €37bn annually in revenues. The literature suggests
this rate errs on the elastic side, implying a large behavioural response. Distortions of
this kind have huge effects on the ‘general equilibrium’, beyond their intended
sphere. Ernst and Young estimate the tax will lead to a net fall in the EU’s revenues
of €116bn. This concern goes to the heart of the theoretic results of taxation
economics. The seminal Diamond-Mirrlees 1971 paper strongly advocates no such
tax on ‘intermediate’ goods, as these propagate through the economic complex,
causing many unintended effects.

What’s more, the evidence suggests the particular behavioural response in this case,
far from calming the markets and edifying those hotheaded speculators, will actually
increase volatility. The Institute of Development Studies finds ‘…the balance of
evidence would seem to suggest that there is a positive relationship between
transaction costs and volatility.’ This of course makes intuitive sense. If the banks put
a charge on ATM withdrawals you would expect people to take out more money less
often. Restraining the ability of traders to follow changes in fundamentals will lead to
jolts in prices and foster uncertainty.

The second issue concerns incidence. The popular discourse on tax invariably
ignores the economic wisdom that he whom a tax is levied on is not necessarily he
who pays. Tax shifting is where the burden of tax is pushed back or forward to other
related parties and again depends on relative elasticities. In most instances this
means employees and consumers end up footing the bill. Two such parties likely to
suffer from this tax are pensioners and emigrants who remit money back to their
home countries.

Tobin described his tax as an ‘anathema to Central bankers’. It is also an anathema
to reason and evidence, which its well-intending sponsors must not ignore.

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