Tobin tax, why not?

By Shin Jang-sup

Tobin tax, why not?

China is quietly rattling the financial world by raising the specter of a Tobin tax. After mentioning the need to introduce the tax about a year ago, Yi Gang, chief of the State Administration of Foreign Exchange and a deputy governor of the People’s Bank of China, said last week, again, that Beijing should implement a punitive levy on foreign-exchange trades and impose “handling fees” to deter currency speculation.

A repeated remark from a top currency regulator that is published in China Finance, an official magazine of the central bank, cannot be taken lightly. In late May, central bank governor Zhou Xiaochuan warned about the risks of China’s stock market bubble in the same magazine. He said an irrational A-share buying spree would probably lead to frothy stocks, with the fundamentals unable to support lofty equity prices. And the A-share boom burst in the following month. It is not surprising that most international media paid great attention to Yi Gang’s remarks and allocated substantial space to analyze its implications.

Nobody can know for sure whether the Chinese authorities will eventually introduce a Tobin tax. In managing foreign exchange policy, the financial authorities have to balance the various and often conflicting needs of its economy. It seems, however, that a Tobin tax makes good sense and China is equipped with an unrivaled capacity to introduce it.

Since James Tobin, a Nobel laureate in economics, suggested this idea after the collapse of the Bretton Woods system in 1972, there has hardly been any criticism about its principles per se. Many countries were already adopting financial transaction taxes on equities and bonds. There is no special reason that currency transactions should be an exception. Moreover, a Tobin tax was proposed as a means to deter short-term speculation, not to increase tax revenues or affect normal currency transactions. Its rate has been thus suggested at a very low level, for instance, 0.005% by proponents of the Sterling Stamp Duty. The actual rate can also be calibrated progressively, making it zero after holding a currency for a certain period. There is hardly anybody opposing the principle that long-term investment should be encouraged more than short-term investment.

Despite its good rationale, a Tobin tax has not been implemented for the last four decades or so. A major reason for this has to do with the fact that most countries fear that they may be stigmatized by introducing the tax: if a country becomes the first to do so, it would be penalized by global investors, rather than having them penalized for speculation. It has been therefore suggested that, if a Tobin tax is to be introduced, it should be done globally. But the global introduction has been naturally opposed by countries that benefit from currency trading. This transaction volume now reaches $5 trillion a day and over $1 quadrillion a year, more than 50 times the world trade volume.

Henry Paulson, former Treasury Secretary of the U.S., famously said when he was chairman of Goldman Sachs, "Volatility is our friend … If it wasn't for volatility, why would you need Goldman Sachs?” Goldman is Goldman because it is equipped with exceptional capabilities to profit from volatility. For most companies and financial institutions, especially those in emerging markets, however, volatility is an enemy, not a friend. A Tobin tax can be understood as a minimum measure to decrease the power of the common enemy of emerging markets so that they can focus more on improving their national and social well-being.

Among emerging market countries, China has the unique capacity to introduce a Tobin tax with less fear. First, its foreign exchange reserves stand at over $3.5 trillion, the largest in the world. The country has unparalleled ammunition to combat potential capital flight. Second, the country’s growth potential is still immense with its economic frontier rapidly expanding to the western inland like the U.S. in the 19th century. Foreign investors would not dare to stop investing in China even if the country implements the tax, which only aims at reducing FX volatility.

Third, China is still employing a managed FX system in which the government’s intention and reading of the market plays a significant role in determining FX rates. A Tobin tax can be part of China’s overall managed FX system.

Fourth, and most importantly in the short run, no trading partner of China, including the U.S., wants to see a further depreciation of the yuan, which may trigger a currency war. China’s trading partners therefore have a strong incentive to dissuade their financial institutions from staging capital flight even if China introduces the tax.

The global financial market is already the largest casino in human history and its size is increasing as rapidly as ever. The real economy is now simply a tiny tail wagged by its speculative activities. There would be hardly any harm to the global community by reducing the size of the casino and thereby reducing expected gains of casino operators and gamblers. It is also not a matter for the global community to be concerned with if some gamblers take flight from the casino or move to another.

If international institutions such as the International Monetary Fund and the World Bank are really concerned with the well-being of emerging markets, they should also support China’s move toward introducing a Tobin tax so that other emerging market countries can follow suit.

Shin Jang-Sup is an economics professor at National University of Singapore and former adviser to Korea's finance minister.