Tobin Tax (Meaning, Example) | Advantages & Disadvantages

What is a Tobin Tax?

Tobin Tax is basically a tax that is levied on short term currency transactions in order to discourage the volatility and speculation. Tobin tax was first proposed by an American macroeconomist and a Nobel Laureate James Tobin. When the Bretton Woods exchange rate system collapsed, fixed exchange rates were replaced with volatile floating exchange rates. To reduce this volatility, a small tax was levied on every amount of currency exchanged into another. This is to discourage the short term speculation of the currencies. This tax is to stop the destabilization of capital flows across the borders & manage exchange rate volatility.

Tobin believed that several problems could be created for small countries because of the massive inflow and outflow of different currencies where they would have to increase the interest rates to keep their currency moving out of their country, but high-interest rates could affect the local economic activities. So, it could generate stability in currency markets which were suffering from disturbances due to the collapse of the Bretton Woods exchange rate. This tax was ignored for many years but people took interest in it during the Asian Financial crisis.

How Does it Work?

Tobin tax is normally levied on short term currency transactions. This levy is to control the money that moves in financial markets in favor of high short term interest rates. Usually, in the short term market, the quick inflows and outflows will make it difficult to manage to central banks. So, the levy of Tobin tax could discourage the volatility & control the speculative capital flows or hot money. Tobin Tax burden is inversely proportional to the period or the length of the transaction. If the holding period is short, then the tax burden will be higher & if the holding period is longer, then the tax burden will be lesser. During periods of global crisis, many countries have introduced these taxes to control the short term capital flows.

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Example of Tobin Tax

Tobin tax was tried in Sweden in 1984. A tax of 0.5% was levied on buying and selling of shares. They could not achieve the results. Only 50 million Swedish Kronors were raised against the expectation of 1.5 billion. In the 1^st week of the tax itself, the trading volume of bonds fell by 85%. Later it was scrapped in 1991. Italy has imposed a tax on high-frequency trading of shares in September’13, 0.02 % of tax is imposed on all the trades which are occurring every 0.5 seconds or faster. In 2016, 11 European countries have proposed the financial transaction tax, where they would levy 0.1 percent tax would be levied on shares and bonds & 0.01 percent tax would be levied on derivative transactions. This approach has given mixed results in many countries that have tried like Chile, Malaysia & Thailand.

Implementation of Tobin Tax

The implementation of the Tobin tax was thought to be difficult if it was made by an individual country. So, it was thought that it could be managed and implemented by an international organization. It has to be internationally agreed to make it work effectively. Regarding the determination of the optimum tax rate, some say that if it is too high, that would weaken the financial markets and if it is too low, it wouldn’t achieve its aim. It could impair the international financial markets operations & create liquidity problems. Exemptions could be provided to certain funds like pension funds etc. Of the total trade volume of currency that is traded every day, only 5% of the transactions are related to trade and are real economic transactions. The other 95% are simply speculative transactions. These speculations can create havoc in national budgets, Economic planning, etc.

Advantages of Tobin Tax

Because of the tax burden, it discourages the inflow of short term speculative capital or hot money.
In case of any destabilizing effects of the capital flows, the government or the central bank will get some gestation time to think of and take necessary measures to counter them.
This tax could reduce the power that financial markets have over the national governments in the determination of their fiscal and monetary policies.
It forms as a part of the revenue for the government.
It will emphasize that investors should more look into macro-economic fundamentals.

Disadvantages of Tobin Tax

This could result in fewer financial transactions that are being made which could result in job losses.
Because of taxes, many funds like pension funds get lesser returns as the banks would simply pass the cost of the taxes to the customers.
This increases the cost of capital of the investors.
Liquidity for the assets will experience a decline.

The areas of implementation of the Tobin tax that determine its effectiveness are establishing a tax base, identification of taxable transactions, determination of tax rates, distribution of tax revenues. In order to limit the financial market distortions, a base for any tax on international financial transactions should be as broad as possible. Tobin tax can be said as a compromise between totally free and strongly regulated international financial markets.

Conclusion

Tobin tax is basically a tax that is levied on short term currency transactions in order to discourage the volatility and speculation. With implementation, governments can raise revenues and also will have enough time to react to any external shocks. There are many instances in the history of this tax being implemented.