Philip Arestis and Malcolm Sawyer
Introduction
The purpose of this chapter is to discuss the contribution which a tax on foreign exchange dealings (often called a Tobin tax) could make to world economic governance. The Tobin tax, at least in its modern formulation,1 began with Tobin’s 1972 Janeway lecture at Princeton (Tobin, 1974; see also 1966, 1978; and Eichengreen, Tobin and Wyplosz, 1995) in which he specifically proposed a tax on foreign exchange transactions as a way of limiting speculation, enhancing the efficacy of macroeconomic policy in the process and raising some tax as a byproduct.2 Some official interest in a transactions tax has been expressed by the United Nations Development Programme (1994) and UNCTAD (1995) who have seen its possibilities for raising large amounts of money which could be used to finance development—Tobin suggests that ‘the revenue potential is immense, over $1.5 trillion a year for the 0.5% tax’ (in UNDP, 1994, p. 70) (see also Michalos, 1997, pp. 23–4).
Volatility, speculation and the efficiency of foreign exchange markets
Much of the reasoning which lies behind the advocacy of a transactions tax arises from the observation of the growing volume of foreign exchange trading.3 The volume of foreign exchange transactions worldwide reached $1,300 billion a day in 1995 (with the corresponding figure in the early 1970s being $18 billion), equivalent to $312 trillion in a year of 240 business days (Tobin, 1996, p. xvi). By comparison, the annual global turnover in equity markets in 1995 was $21 trillion, the annual global trade in goods and services was $5 trillion (and total reserves of Central Banks around $1.5 trillion at the end of 1995). A tax on foreign exchange dealings would clearly be expected to reduce the volume of those dealings. But more significant than this growth in the volume of foreign exchange dealings is the perception that the exchange markets are not operating in an overall beneficial manner. The defenders of the exchange markets would
view them as efficient—using the term efficient in a number of ways. Efficiency here would include the notion of ‘efficient markets’ in which information is rapidly absorbed into the price (and hence that prices follow a random walk), and also the idea that there are (social) benefits (e.g. of risk spreading) from trading in the exchange markets which match the (social) costs. An alternative view, on which we would see much of the case for the Tobin tax resting, starts from a different analysis of competitive markets (which we take the exchange markets to be) associated with Keynes and others.4 This emphasises the role of expectations, conventions and perceptions of the views of others (‘we devote our intelligences to anticipating what average opinion expects the average opinion to be’, (Keynes, 1936, p. 156)), the instability which arose from speculation and the suggestion that long term commitment should be encouraged. Market operators are more concerned with the rate of change of price than with the price level.
This has variously been described as, for example, ‘noise’ trading and trading motivated by price dynamics. This approach would suggest that exchange rates are rather volatile, that there are periods of substantial overvaluation (relative to some norm such as purchasing power parity or consistency with trade balance) and others of substantial undervaluation, and that the resources devoted to exchange dealings may be excessive.
In so far as foreign exchange dealing (for speculative purposes) is a zero-sum game, undertaken because of different expectations on interest rate and exchange rate movements, then a lower volume of transactions does not entail any costs (though there would be a redistribution of benefits and costs). It is argued that arbitrage through foreign exchange dealings brings about an equalisation of interest rates (adjusted for expected exchange rate movements), and that a
‘thicker’ market would encourage a speedier return to equilibrium and to such an equalisation of interest rates across countries. Assuming that such equalisation brings a benefit, even then we do not know what volume of transactions would be required to bring it about: indeed the theory of efficient markets would suggest that very few, if any, transactions would be required for any such equalisation. Thus, if the foreign exchange market has elements which could be seen as efficient (with respect to use of information), then the current volumes of transactions would not be required in order for the exchange rate to be in line with ‘fundamentals’. In order to establish the optimal amount of trading it would be necessary to establish the extent of foreign exchange required for international trade, direct and portfolio investment.
There is now an extensive literature which indicates that financial market prices can be over- or under-valued for substantial periods of time (and casual observation of the movements in the exchange rates in the past twenty-five years, reflected to some degree in Tables 7.1 and 7.2, would be supportive of that view), and in that sense suffer from medium-term volatility. The work of Shiller (e.g. Shiller, 1981, 1984, 1990, and the papers in Shiller, 1989) has strongly suggested that there is excessive (medium term) volatility in the stock and bond markets. Further, there are theoretical literatures (surveyed by, for example,
Camerer, 1989) which show that behaviour which could be termed as rational or
‘near rational’ at the level of the individual can generate ‘bubbles’.5 Indeed, bubbles can be an intertemporal manifestation of markets having ‘multiple’
equilibria. Under these circumstances bubbles ‘need never break’ (Stiglitz, 1990, p. 14). Also under the assumptions of uncertainty and of investors being short- lived and risk averse, again ‘bubbles need not be completely eliminated’
(Shleifer and Summers, 1990). Even if there are some risk-averse and some risk- loving speculators, to the extent to which they have limited access to capital, they are likely to have only a limited impact on markets—a result which is consistent with the Stiglitz and Weiss (1981) analysis of capital markets under asymmetric information. In a world of uncertainty where knowledge of the economic fundamentals is given to few it is perhaps inevitable that asset prices will fluctuate and follow fads and fashions.
Most economists today believe ‘foreign exchange markets behave more like the unstable and irrational asset markets described by Keynes than the efficient markets described by modern finance theory’ (Krugman, 1989). Isard (1995) suggests that ‘few [economists] still believe that the behavior of flexible exchange rates can be accurately described by a model based on the hypothesis that market participants are both fully rational and completely informed about the structure of the model and the behavior of relevant macroeconomic fundamentals’ (p. 182).
The term volatility suggests an instability on a short term basis, e.g. variance of price or price change measured on a daily basis. It can, of course, be the case that there is considerable volatility on this basis and yet the market be deemed efficient (in the sense that there is a lack of correlation between daily price movements). But this volatility may be inconvenient for those involved in international trade because of the uncertainty which it engenders, though the use of forward contracts can reduce the uncertainty. Volatility which involved minor fluctuations around the ‘fundamental’ equilibrium exchange rate would be little more than a nuisance. The aspect of exchange rate movements since the early 1970s which is of more significance is the year (or longer) to year volatility which has generated substantial periods when exchange rates are substantially over- or under-valued. This medium and long term volatility cannot be escaped through the use of forward contracts (which generally do not extend more than 12 months into the future), and is likely to have a much more significant impact on international trade than short term volatility.
There can be little doubt that the era of flexible exchange rates since 1971 has been associated with a considerable degree of volatility of exchange rates. Some crude indicators show that since 1980 on average the standard deviation relative to the mean of the sterling/DM rate was 3.9 per cent on a monthly basis, and the ratio of the maximum to minimum during a year varied from 5 per cent (in 1991 the only full year for which sterling was a member of the ERM) and 22 per cent.
There is also considerable variation in the month to month changes with an average standard deviation of 2.33 per cent. Comparable figures for the dollar/
yen rate were 5.2 per cent for the standard deviation relative to the mean, a ratio of maximum to minimum up to 30 per cent and a standard deviation of monthly changes of 2.83 per cent. These figures suggest significant volatility within a year, as well as suggesting considerable variation in the real value of the exchange rates.
Mussa (1986) calculates the changes in the logarithm of ratio of price levels in the two countries concerned, of the nominal exchange rate and of the real exchange rate. He concludes that under floating exchange rates, ‘there is a strong correlation between short-term movements in the real exchange rate and shortterm movements in the nominal exchange rate’ (p. 131). Further, ‘short-term changes in nominal exchange rates and in real exchange rates show substantial persistence during subperiods when the nominal exchange rate is floating’ (p.
132). He makes many cross-currency comparisons, and not surprisingly there is a wide variation in the degree of variability in bilateral exchange rates. Variances of up to 25 per cent per quarter are found, implying a standard deviation of 5 per cent per quarter: this would of course mean that in approximately one-third of quarters the rate of change deviated by more than 5 per cent from the average.
Further evidence is provided in Rose (1994) (cited by Eichengreen et al, 1995).
Rogoff (1996) poses what he terms the purchasing power parity puzzle, which is
‘How can one reconcile the enormous short-term volatility of real exchange rates with the extremely slow rate at which shocks appear to damp out?… Consensus estimates for the rate at which PPP deviations damp…suggest a half-life of three to five years, seemingly too long to be explained by nominal rigidities’ (pp. 647–
8).
The possible costs of volatility are well-known even if they are difficult to quantify and are subject to some debate. Volatility engenders a degree of price uncertainty, making effective decision-making more difficult. The price (of currency) uncertainty may lead firms to be reluctant to engage in international trade and thereby reduce the volume of international trade. Others (e.g. Krugman, 1989) suggest that uncertainty over exchange rates generates incentives for firms to postpone investment in export (or import substitution) capacity that would be difficult to reverse. In the context of exchange rate volatility, there may be asymmetric responses to the upward and downward movements of the exchange rate. An over-valued exchange rate reduces export demand, leading to a decline in the domestic tradable goods sector and a reduction of capacity (or a failure to invest) in that sector, and this may not be fully compensated by the stimulus of export demand coming from an under-valued exchange rate in terms of the opening of new capacity. The effect of volatility on policy-makers can be a further concern in so far as volatility generates uncertainty and deflationary responses. If say a fall in the exchange rate (arising from the volatility of the exchange rate and unconnected with real variables) generates a deflationary response (e.g. increase domestic interest rates) there are detrimental effects on the domestic economy. This may, of course, be offset by a reflationary response to a rising exchange rate, and if the policy responses are symmetrical there would
appear to be no net damage. Even so, there may still be some harm in so far as sudden and frequent changes in exchange rate movements generate changes in the economic policy stance, and thereby a more uncertain economic environment.
However, Frankel (1996), drawing on the survey of Goldstein (1995), argues that ‘Most studies have concluded that short-term volatility has little effect on trade’ (p. 52). But a study by Frankel and Wei (1995) on bilateral trade ‘shows statistically significant effects of bilateral volatility in the 1960s and 1970s’
(Frankel, 1996, p. 52). Isard (1995) similarly concludes that ‘empirical studies have failed to uncover statistical evidence that exchange rate variability has had much of a depressing effect on international trade volumes’ (p. 196). However, we can note the conclusions of Gagnon (1993) based on a theoretical approach that ‘under a very extreme combination of assumptions, the breakdown of Bretton Woods is estimated to reduce the level of trade by about 3 percent. This effect is shown to be too small to detect statistically. A further increase in exchange rate variability would lower the volume of trade by a statistically significant 9 percent, but this latter scenario requires a degree of exchange rate variability much larger than has been observed historically’ (p. 287).
One advantage of such a reduction would be to reduce the relative influence of financial and short term factors on the exchange rate and to increase the relative influence of real factors. Harcourt (1995) argues that ‘if we want exchange rates to reflect real economic forces—trading prospects, real investment opportunities
—we need greatly to reduce speculation and thereby its effects on the determination of exchange rates in both the short and longer term. For neither in the short term nor on average over longer periods do exchange rates at the moment reflect these economic activities’ (p. 34).
It would be usually assumed that very short term foreign exchange transactions (say those involving a round trip of less than one week) would be largely undertaken in pursuit of gains from movements in the exchange rate, and not for gains from interest rate differentials. Even if transactions costs were as low as 0.1 per cent, then on a round trip of one week the anticipated interest rate differential would need to be 5.3 per cent expressed on an annual basis (with no expected compensating movement in the exchange rate) in order for a switch between currencies to appear profitable. In contrast, long term foreign exchange transactions could be expected to be more geared towards differentials in the rates of return, and small differences in the annual rate of return may be sufficient to generate capital flows.
However the short term and the long term flows are similar in that capital flows proceed if the anticipated (presumably risk adjusted) return is greater than the transaction costs involved. Thus, for any given expected change in market price that exceeds the total tax imposed, speculation is profitable regardless of whether the expected change is of one day, one week, or one year, or even longer. From that angle, a transactions tax may have a similar relative effect on short term and on long term transactions. In both cases (and the intermediate ones as well), the effect of the transactions tax would depend on the frequency of returns lying
between the current transactions costs, and those costs plus a transactions tax, where the returns are calculated over the expected holding period. Hence a transactions tax would have a greater effect on short term transactions than on long term transactions if the frequency distribution of the former (around the current cost) is denser than the corresponding distribution for the latter. We could expect this to be the case from the following illustration. Over say a week the frequency distribution across individuals as to their expectations of the change in the exchange rate may well cluster between say +1 per cent and −1 per cent, whereas the distribution of expectations on interest rate differentials could cluster between say +3 per cent and—3 per cent per annum, and hence a wider distribution over say five years is more likely. With those illustrative numbers, a 0.1 per cent transactions tax is likely to eliminate for active consideration a higher proportion of the short term exchanges than the long term ones. We would have to stress that these numbers are only illustrative but may catch the flavour of the case that a transactions tax would have more effect on short term transactions than on those designed to be long term ones. On that basis, a transactions tax may have more impact on short term volatility than on medium or long term volatility (if there is a link between the volume transactions and volatility), though it is the medium or long term volatility which is the more costly.
Attempts at fixed exchange rates are made much more difficult by the volume of transactions. This is reflected in: ‘Modest uncertainty about whether national monetary authorities are inclined to make use of their theoretical independence can lead to significant financial market volatility. If currencies are floating, they can fluctuate widely. If the authorities attempt to peg them, the costs of doing so, measured by reserve losses or interest-rate increases, can be extremely high.
Even a government otherwise prepared to maintain a pegged exchange rate may be unwilling or unable to do so when attacked by the markets and forced to raise interest rates to astronomical heights’ (Eichengreen, Tobin and Wyplosz, 1995, p.
162).
Foreign exchange dealings absorb resources, and a reduction in the volume of dealing would reduce the resources devoted to dealing. Frankel (1996, p. 61) suggests ‘a typical transaction cost for foreign exchange might be 0.1 per cent’
though much smaller for interdealer trading. Felix and Sau (1996) use the much higher figures of 0.5 per cent and 1.0 per cent for the transaction costs. But they also report that ‘the quoted bid-ask spreads on trades of major currencies in the
“wholesale” foreign exchange market (trades less [sic] than $50 million) over the electronic network are usually less than 0.1%… The spreads are doubled for
“retail” trades (less than $5 million) and can rise to more than 1.0% for small retail transactions’ (p. 231). However, other figures on the bidask spread are much lower (noting that transaction costs are broader than the bid-ask spread):
Kenen (1996) states that ‘spreads in the wholesale market are well below 10 basis points [i.e. 0.1 per cent] for the major currencies’ (p. 110).
On the basis of the estimates given above on the volume of transactions, a figure of 0.05 per cent for transaction costs would suggest a total cost of $150 billion per annum (in 1995). This may suggest that if a transactions tax halved the volume of transactions, and assuming that the transaction costs reflect resource costs, then annual savings of the order of $75 billion (£50 billion) could be involved (i.e. more than 6 per cent of UK GDP, and nearly 0.4 per cent of OECD GDP). This figure may be an over-estimate if there are economies of scale in foreign exchange transactions and to the extent that the foreign exchange transactions which are reduced are concentrated amongst those which attract lower transaction costs (e.g. in the wholesale market).
Tax-raising potential
The second line of reasoning for a transactions tax is simply its tax-raising potential. Tobin (1978) suggested this possibility as a by-product of a transactions tax, not as the main aim of his proposal, but others (e.g. United Nations Development Programme, 1994) put more emphasis on the revenue aspects. The revenue aspects may be linked with the view that the financial sector is relatively under-taxed in the sense that financial transactions do not usually bear general sales or value-added taxes nor are they usually subject to specific taxes in the way in which, for example, tobacco and alcohol are. Calculations for OECD (1995) for OECD countries indicates that on average such taxes account for 1.3 per cent of tax revenue. However, most countries do have such taxes (see Campbell and Froot, 1994, summarised in Frankel, 1996, for an indication that there are only a few industrialised countries without any transactions taxes; and Spahn, 1995, pp. 51–4). It could also be added that a Tobin tax ‘would tend to be progressive because relatively low income people would not be involved in the capital transactions captured by the tax’ (Michalos, 1997, p. 31).
The tax-raising potential of a transactions tax is considerable. The most widely cited figures on turnover on the foreign exchange markets are summarised in Tables 7.1 and 7.2. In April 1992, the gross daily turnover was estimated at over
$1.3 trillion, which comes down to around $1.08 trillion when local double- counting is eliminated. This represented a growth of 50 per cent in three years.
For April 1995, the figure had grown again by nearly 50 per cent to $1.57 trillion.
After adjustments for cross-border double-counting and for gaps in data, the net daily turnover was estimated at $880 billion in 1992 and $1.25 trillion in 1995. The latter figure generates, on the basis of 240 business days, an annual turnover of
$300 trillion. World trade for 1995 is a little over $5 trillion6 suggesting a multiple of financial transactions relative to world trade of around 60.
The estimation of potential tax yield would clearly require estimates of the price-elasticity of the volume of foreign exchange transactions, and of the degree of tax avoidance and evasion which could be expected to be involved with some shift to untaxed transactions (e.g. to countries which do not impose the tax) and also to non-reporting of transactions which should be subject to tax. The