Between the Lines: Global taxes are undoubtedly the next step – just not this one

Published on Tuesday 15 September 2009 21:44

GERMANY'S ambitious finance minister, Peer Steinbrück, has lobbed a firework into the preparations for next week's G20 summit in Pittsburgh, which is set to discuss how to regulate the world's financial system.

Herr Steinbrck proposes a global tax on all cross-border financial transactions – a so-called Tobin tax, named after the American Nobel-winning economist James Tobin, who invented the idea back in the 1970s.

The aim is to discourage risky, speculative trades. Steinbrck's novel twist is that the receipts would be used to repay the cost to governments of tackling the current economic disaster. "The cost of the crisis should not be borne alone by small taxpayers," he argues.

But Steinbrck's idea is unlikely to get very far at Pittsburgh, largely because it was designed to upstage his political rival, Angela Merkel, who is leading the German delegation. However, the idea of a Tobin tax to curb the excesses of the global financial markets is back in fashion – last month it got the support of no less a player than Lord Adair Turner, head of the Financial Services Authority.

Turner thinks a Tobin tax could curb the size of the bloated financial sector and discourage excess bonuses based on unwarranted risk-taking. He argues that "the idea that more liquid markets are definitionally good" has been destroyed by the financial meltdown.

James Tobin first floated his tax in 1972, at a time when the international system of fixed exchange rates had collapsed under speculative pressures. He was worried that freely floating exchange rates would be destabilising to world trade, so he suggested taxing currency transactions to dampen short-term speculation.

The idea was instantly rejected as unworkable by the financial establishment. The then chief economist at the German Bundesbank, Otmar Issing, dismissed it saying: "It's the Loch Ness monster popping up once more."

In one sense, Issing was correct, for world trade and tourism increased with flexible exchange rates while governments were relieved of the burden of having to restrict domestic growth to keep currency rates fixed.

However, the Tobin tax took on a new lease of life as a potential mechanism for funding Third World development. Non-governmental organisations claim that a 0.005 per cent tax on international financial transactions could raise between 18 billion and 35bn a year – enough for the G7 countries to meet their Gleneagles summit promise to double aid.

But the fundamental problem with a Tobin tax is it has to be universal or the nations where it is imposed will lose financial business to markets who ignore it. That is why it is a non-starter. The only way round this difficulty is if the cash was used to, say, finance a shift to clean energy in Brazil, India, Russia and China, which would give those countries the incentive to join in.

Next, there's the problem of complexity. To stop the substitution of taxable transactions by tax-free ones, the Tobin tax would have to cover many financial instruments, including new ones created to circumvent regulation. For instance, a tax on spot transactions could be avoided by using short-dated forward transactions. Who is going to police this? One suggestion, from US economist Dean Baker, is to give honest traders who turn in their cheating institutions a cut of the receipts as a reward.

Practicality aside, a Tobin tax would have implications for how markets function. The largest part of daily global exchange transactions are done for the purposes of hedging to avoid over-exposure in currencies accumulated from deal-making. This practice is essentially a form of insurance. A Tobin tax would, by definition, discourage hedging and so actually increase risk.

Today's key problem is not short-term volatility (which can be hedged) but the long-term misalignment of exchange rates and trade balances, notably between China and the West. It was the accumulating Chinese surplus that fuelled the American and European credit bubble that has just burst. Theoretically, a Tobin tax could block the transfer of such surplus funds to western banks, but it would have to be set at a punitive rate – and why would the Chinese agree to be taxed?

Don't get me wrong: the next step in multilateral politics is undoubtedly the introduction of global taxes. But I suspect we may start with a carbon tax, which is altogether easier to manage.