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 a volatile floating exchange rateFloating Exchange RateThe floating exchange rate can be defined as the relative value of the currency of a country. It is determined on the basis of the demand and the supply factors prevailing in the Forex market and no attempt is made by the government for influencing such exchange rate.. For reducing this volatility, a small tax was levied on every amount of currency exchanged into another. It 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. Still, high-interest rates could affect local economic activities. So, it could generate stability in currency marketsCurrency MarketsFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange., 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 an interest in it during the Asian Financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors..
How Does it Work?
Tobin tax is generally 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 challenging to manage to central banks. So, the levyThe LevyA levy is a lawful process where the debtor's property is seized when the debtor cannot pay the outstanding debts. It is different from liens, as a lien is only a claim against a property, whereas a levy is an actual property takeover to fulfill the obligation. of Tobin tax could discourage the volatility & control the speculative capital flows or hot moneyHot MoneyHot money refers to the portfolio of funds that are actively invested in diversified assets (stocks, deposits, bonds, commodities currencies, and derivatives) with the intention to take advantage of any available short-term opportunity to earn higher short-term returns. . 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 more extended, 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.
Example of Tobin Tax
Sweden tried Tobin tax in 1984. They levied a tax of 0.5% on buying and selling of shares. They could not achieve the results. Sweden could only raise 50 million Swedish Kronors against the expectation of 1.5 billion. In the 1st week of the tax itself, the trading volume of bonds fell by 85%. Later it was scrapped in 1991. Italy imposed a tax on high-frequency trading of shares in September’13. They imposed 0.02 % of tax on all the trades occurring every 0.5 seconds or faster. In 2016, 11 European countries proposed the financial transaction tax, where they would levy 0.1 percent tax on shares and bonds & 0.01 percent tax on derivative transactions. This approach gave mixed results in many countries that tried it, like Chile, Malaysia & Thailand.
Implementation of Tobin Tax
The implementation of the Tobin tax was thought to be difficult if an individual country made it. So, it was felt 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 will weaken the financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces., and if it is too low, it won’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 volumeTrade VolumeThe volume of trade is the overall measure of the number of securities, shares or contracts traded during a particular trading day. 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 policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc..
- It forms as a part of the revenue for the government.
- It will emphasize that investors should look more into macro-economic fundamentals.
Disadvantages of Tobin Tax
- It 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.
- It 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. For limiting 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 global financial markets.
Tobin tax is a tax levied on short term currency transactions to discourage 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.
This article has been a guide to what is Tobin tax and its meaning. Here we discuss how does Tobin tax work along with its example, advantages and disadvantages. You can learn more about financing from the following articles –