Tobin or not Tobin?

Posted by Sony Kapoor on 10 October 2009

We are still in the midst of the financial crisis brought upon us by excesses in the financial sector. The recession this triggered has squeezed tax revenues. This, together with the trillions of dollars spent by governments around the world to rescue the financial sector and stimulate the broader economy has increased the prospects of a fiscal crisis with many rich and poor country governments facing budget deficits of an unprecedented magnitude. The search for ways to regulate the financial sector and plug fiscal deficits has led to a renewed interest in the Tobin Tax as well as the broader family of Financial Transaction Taxes.

Adrian Turner, the chief UK regulator recently expressed support for a worldwide Tobin Tax to curb the size of the financial sector. Sarkozy and Merkel talked about FTTs as a way of increasing revenue from the financial sector to ‘make it pay for its rescue’. Even ‘Senator Obama’ had expressed support. Another attraction is the potential positive impact these taxes might have on stabilizing financial markets by skewing incentives towards long term investments and away from short term speculation. FTTs are also widely seen as an attractive source of revenue for funding development. The financial crisis and the regulatory response have made FTTs both more desirable and easier to implement.

Exponentially larger financial markets

Financial markets of all kinds have expanded massively. Currency market turnover, for example, rose from about $4 trillion in the 70s to $40 trillion in the 80s to more than $500 trillion now. Turnover in equity markets registered a seven fold increase between 1993 and 2005 to about $51 trillion and the notional value of OTC credit default swaps alone rose to more than $60 trillion from almost nothing a decade ago.

It is well-understood now that this expansion is not unambiguously positive. Those who insisted that this rise in turnover was an indication of higher liquidity have been proven wrong by the liquidity black hole brought about by the crisis. Liquidity comes from having a diversity of participants and views in the financial markets not a high turnover ratio.

Major financial market actors have been large users and providers of tax avoidance schemes in the past and have generated enormous wealth for themselves and a large tax burden on the ‘little people’ in society. The fast descent of the financial sector towards ‘business as usual’ complete with enormous bonuses shows how they are likely to escape paying their fair share again.

Taxing financial transactions for a fairer burden sharing arrangement

The financial transaction tax offers an attractive tool for implementing fairer burden sharing arrangements. Such taxes have the potential to generate revenue at even very low levels (a few basis points) of taxation simply because the volume of transactions is so high. Various estimates show that such taxes could raise predictable, stable, and easy to collect revenues in the range of hundreds of billions of dollars annually. Figures of the range of 0.5%-2% GDP annually have been reported by several studies.

This money could then be used in a variety of ways – for example to reduce other taxes such as income taxes especially on the lowest levels of income, to repay governments debts, to fund development, to build up a contingency fund or to recover the costs of the bailouts. All of these would result in a fairer burden sharing across citizens belonging to various income groups.

Financial transaction taxes have been successful

Financial Transaction taxes have been around for hundreds of years with the Stamp Duty on the trading of shares in the London Stock Exchange being one of the oldest still around. This tax, which is now, levied electronically at 0.5% (50 basis points) of the face value of share purchases collects more than $7 billion every year. The London stock exchange in the meantime continues to be the one of the world’s most liquid exchanges. Clearly any negative impact on the market can be easily contained.

EU members Austria, Ireland, Greece, France and Finland levy taxes on stock transactions and Austria, Belgium, Germany and Greece impose taxes on bonds. Countries such as India, Colombia, China, South Korea, Ecuador, Hong Kong and Australia also have operational financial transaction taxes. Even the United States levies the section 31 fee on financial transactions which funds the Security Exchange Commission. This is an interesting model where the financial markets pay for their own regulation and can be expanded also to include not only paying for all financial market regulation and supervision but also for rainy day financial bailout funds and past bailouts.

Cheap and Easy to Collect

As an increasing number of financial transactions are done electronically and even OTC derivates and currency transactions move towards centralized electronic settlement, financial transaction taxes are becoming cheaper and easier to collect. All that is really needed is the addition of a line of software code to existing messaging and settlement systems. In the UK, for example, the Stamp Duty is 100 times cheaper to collect than an equivalent amount of income tax.

Progressive Incidence

While it is true that institutional investors such as pension funds etc own a significant proportion of the financial markets, financial transactions are still disproportionately conducted by the richer segments of society either directly (through in house asset management) or through vehicles such as hedge funds. More than 25% of financial assets in the United States, for example, are owned by the top 1% richest population. Before the crisis hit, hedge funds were believed to be responsible for as much as 50% of trading volume in certain markets. Financial transaction taxes will have a highly progressive incidence as opposed for example to sales taxes or value added taxes which are regressive.

Difficult to Evade and Avoid

Because financial transactions leave an electronic trail and/or are settled at a central clearing centre, financial transaction taxes are next to impossible to avoid. The other reason they are difficult to avoid is that they are collected automatically either at the point of the initiation of the transaction or at the point of their settlement. While there have been some fears of transactions moving offshore to avoid unilaterally implemented taxes, these are exaggerated. In fact, in Brazil, the information generated by the financial transaction tax was successfully used to reduce the evasion of other taxes. This evasion reducing effect could be easily replicated in other countries.

No tangible impact on market efficiency

Despite the fact that such taxes are often labeled as market unfriendly the wide variety of successful FTT regimes that operate around the world show that they are easy for markets to bear especially when the rates are low. Low rates also mean that few financial transactions undertaken for economic reasons would be effected. For example, at rates of a basis point or less these taxes are below the radar screen of most traders.

Compared to the transaction costs that arise from 1) brokerage fee 2) exchange fee 3) short term volatility of prices 4) market movement in response to transactions etc, the levels of taxation of 1-5 basis points that are being discussed remain negligible. In most instances, levying such taxes would take transaction costs back to the level they were at 3-4 years back at which point no one accused the financial markets of ‘being distorted’ or ‘illiquid’.

Potentially market stabilizing

Being a turnover tax, the FTT will penalize shorter term trading and have hardly any impact on those with a longer term investment horizon. Consider a stock transaction tax of 0.1% for instance. A trader with a daily investment horizon would on average trade once a day and end up paying a 250*0.1 = 25% effective tax rate. A pension fund with a five year horizon, on the other hand, will end up paying only 0.02% or 1/1250th the rate of the daily trader.

This would discourage the kind of very short term (computer run high frequency trading) financial transactions that destabilized the markets in 2007 and leave the longer investment horizon investors unaffected. Hence FTTs are likely to have a market stabilizing impact. High frequency traders, by having access to information earlier than other actors also tilt the market landscape in their favour so FTTs are likely to make financial markets fairer. Differential taxation of systemically risky products such as complex derivatives is also likely to enhance the stabilizing impact of FTTs.

Significant revenue potential

Financial transaction taxes levied across a broad range of financial markets can generate hundreds of billions of dollars of revenue worldwide without too much distortion of financial markets. Once bank debit taxes, which routinely collect as much as 2%-3% of revenue in many Latin American countries, are included, the revenue potential increases substantially. Stock, bond, currency and derivate market transaction taxation are likely to all produce more than $40 billion of revenue each. Including bank debit taxes easily doubles the revenue potential.

The crisis has made it much easier to impose FTTs

In the aftermath of the collapse of Herstatt Bank in 1974 regulators started looking for ways of reducing settlement risk in currency markets. This search ended with the establishment of the Continuous Settlement Bank which allows for the real time gross settlement of currency transactions. This system has proven its worth by being a sea of stability in otherwise stressed financial markets during the current financial crisis. As a consequence, regulators are in the process of pushing and increasing variety of financial transactions in the direction of increased on exchange trading as well as centralized clearing and settlement. Even for OTC derivatives where this may not be possible there will be a regulatory requirement to register all transactions with the regulators.

The electronic nature of financial transactions, the unavoidable audit trail, the centralized clearing and settlement and the mandated reporting and recording of transactions will all make it much easier and cheaper to implement transaction taxes in most if not all financial markets. The expansion of the boundary of regulation to new institutions, markets and jurisdictions will make it even harder engage in already difficult and expensive evasion.

Financial transaction taxes are taxes of the future and the financial crisis presents both several reasons as well as several opportunities for a rapid expansion in the implementation of these taxes across an increasing number of financial markets. Expect that to start happening soon.

Sony Kapoor is the Managing Director of Re-Define (Re-thinking Development Finance & Environment, an international Think Tank dedicated to improving the Development, Environment and Governance footprint of the financial system.

Note: This piece is based on a report written by the author for the Norwegian government in 2007 and on a seminar address delivered at the German Ministry of Finance in July 2009.


Taking the Next Step – Implementing a Currency Transaction Levy, Hillman, Kapoor & Spratt, Norwegian Government, 2007 :

Financial Transaction Taxes and the Currency Transaction Levy, Sony Kapoor speech at the Innovative Finance Conference organized by the Norwegian Government, 2007:

A Financial Market Solution to the Problems of MDG Funding Gaps and Growing Inequality, Sony Kapoor speech at the Innovative Finance Conference hosted by the Korean Government, 2007:

Transaction Taxes: Raising Revenues and Stabilizing Markets, Report for a Project financed by the Co-operative Bank, Sony Kapoor, 2004