16 June 2010

The Taxing Issue of the Tobin Tax: What Does the Evidence Say?

The Tobin Tax is a proposal to tax financial transactions and is named after the Nobel prize winning economist, James Tobin. Its advocates say financial transactions taxes will reduce market volatility thereby increasing investment and will raise much needed revenue for public goods. Detractors say they are unworkable and that in any case we should be working to lower not raise transactions costs.

So who is right? Hot off the press comes an IDS review paper written by Neil McCulloch and Grazia Pacillo and supported by DFID.

The paper reviews the evidence from around 100 papers on these four questions:

1. What is the impact of financial transaction taxes on volatility?
2. Is a financial transactions tax feasible?
3. How much money would a financial transactions tax collect?
4. What is the incidence of such a tax? In other words, which groups in society would it affect?

Will a Tobin Tax Reduce Volatility?

The theory here is that a tax on each transaction represents a much heavier relative burden on a short term than a long term investment, hence incentivizing long term investments, which are thought to lead to greater stability, less uncertainty and higher overall investment. Theoretical and simulation work confirms this intuition. However, the empirical evidence suggests no decrease in volatility and in a few cases, even an increase.

Is a Tobin Tax Workable?

The devil is in the details here. Which financial instruments to tax (futures, swaps, equities, bonds, spot transactions)? Should the tax rate be the same for all instruments? Should taxes be national or market based? At what point should tax be imposed in the system—at deal, at booking or at settlement? Do all countries have to act together? Although these questions are not easy, there is a large literature on these questions and the consensus is that a Tobin Tax could be successfully implemented.

How Much Money Would a Tobin Tax Collect?

There is a huge variation in the estimates, depending on the resources liable for tax, the tax rate applied and the assumptions about lower volumes of trade as a result of a higher price of trading. The paper constructs a range of meta–estimate of revenue potential. For example a tax equivalent to 10% of transactions costs applied to forex, equities and derivatives would raise $415 billion world-wide and $135 billion if only applied in the UK. If a tax rate of 0.005 % was applied only to spot transactions it would raise $26 billion globally and $11 billion in the UK only.

Who Would be Affected by a Tobin Tax?

Would this really soak the rich? Or would it simply be passed on to consumers? The evidence base is weakest here, but given the likely higher cost of capital, the authors tentatively conclude that the Tobin Tax would likely be no less progressive than other forms of taxation. For me, this is the weakest section in an excellent paper.

What is really interesting is that we get a sense that the authors were surprised by their findings. The review made them more predisposed to a Tobin Tax than they were prior to having done the review. For why that is so you will have to email them yourselves!

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