"Taxing Currency Transactions for Development"
One of the newest and most innovative methods to generate new resources for development involves the regulation and taxation of international capital flows. Currency transactions taxes, adopted nationally and coordinated regionally or internationally, provide a means by which unstable and untaxed capital can be re-regulated in the interest of financial stability and revenue generation for development.
The Need for Financial Market Governance
To Control Systemic Financial Instability
The financial crises of 1997- 1999 exposed the systemic instability of global finance and resulted in devastating impacts on human development. Recent trends to liberalize financial flows globally have increased not only the volume of transactions, but volatility in recent years, inviting destabilizing speculation and abrupt capital flow reversals. While the causes of the Asian financial crises were many and will not be addressed here, the immediate cause was the sudden exodus of capital – US$12 billion in 1997 alone. In Brazil, an estimated US$ 50 billion left the country within six months in 1998. Financial liberalization has meant that governments have largely surrendered their ability to control the global flow of capital.
The ease with which enormous quantities of portfolio capital, unconnected to productive investment, move around the globe, coupled with dramatically increased volume of flows, threatens the national economic security of all nations. From 3.5 times the level of dollar value of exports in 1977, foreign exchange transactions rose to 68 times the value of world exports by 1998. In 1998, the global daily foreign exchange turnover was $US1.98 trillion per day. Total reserves of all the world’s countries are now less than one day’s trading in foreign exchange markets. Many countries can no longer defend themselves against speculative attack, effectively surrendering monetary and economic policy sovereignty to private individuals, investment houses and large banks.
Because financial markets rely on imperfect information and highly subjective signals, they are subject to boom and bust cycles independent of underlying economic fundamentals. Even countries with their economic “house in order” are vulnerable to attack. The threat of financial instability is therefore not limited to the developing countries, though their thin markets make them more vulnerable.
The financial crises revealed the degree to which financial markets are under-governed in the global economy. An enormous discrepancy exists between an increasingly sophisticated international financial world and the lack of proper institutional frameworks to regulate it at the national and multilateral levels. The inevitability of future crises makes the re-regulation of capital a global imperative.
To Foster Development
The Asian crises demonstrated the extent to which development is undermined by financial instability. When currency values collapsed in the wake of speculative attack, prices skyrocketed, wages fell, companies unable to pay debts denominated in foreign currencies went bankrupt and joblessness soared. Three decades of poverty reduction and economic growth was wiped out in the region. The crisis threw 10 million people into “extreme poverty” (under US$1 a day) and an extra 23.8 million into “poverty” (under US$2 a day).
While all the affected countries are now out of recession and growing economically, living standards have not recovered. In Thailand, real wage levels in construction, commerce, agriculture and services continue to spiral downwards. In Indonesia, food prices are still 30-40% higher than they were before the crisis. In South Korea, the gap between the rich and poor is the highest in decades.The human crisis in affected countries is an ongoing one and will take decades to reverse.
Inadequate Multilateral Crisis Response Post-Crisis
In response to the global financial crises, industrialized nations established international forums to propose measures to reform the international financial system. The underlying assumptions guiding these fora - that the primary causes of the crises were inadequate provision of information to investors and inappropriate developing country policies - are too narrow and fail to address the systemic nature of the problem. The solutions proposed to date including increased transparency and data reporting, as well as IMF surveillance and control of developing country financial systems, are therefore fundamentally flawed.
Increased information will not prevent volatility. Investors can never obtain sufficient information about future prices and costs to enable them to estimate risk vs. return accurately; these are inherently subjective judgements. Panic selling and herd behavior arises from psychological perceptions not empirical evidence. As the Asian crises clearly demonstrated, currency values plunged far in excess of what underlying economic fundamentals would have indicated. Speculators have a vested interest in creating and maintaining volatility as profit potential increases in volatile markets. Until the incentive for speculation is removed, markets will remain volatile and crises, inevitable.
In addition to being ineffective in preventing crises, proposals to increase IMF surveillance and control of developing country finance policy effectively place the fox in the chicken coop. In spite of lessons on the contributory effect of financial market liberalization to financial crises, IMF management remains committed to the full liberalization of the capital account of its member nations. Measures to reform domestic financial institutions and markets to better meet the demands of liberalized foreign capital flows only set the stage for future crisis. Additionally, the inability of the IMF to effectively anticipate difficulties pre-crisis, when risky lending to overvalued stock and bond markets was already evident, has seriously eroded the institution’s credibility even in the most conservative circles. This failure calls into question the Fund’s adherence to ideological assumptions over empirical evidence. Finally, in light of the IMF’s widely acknowledged role in exacerbating the financial crises through its bailout package conditionality, any proposal to increase IMF control over member country finance policy is counter intuitive.
1.3 The Means to Re-Regulate Capital and Generate Resources for Development
Until measures are enacted to prevent systemic financial market volatility, human development will be threatened. India and China, the countries least affected by the Asian crisis, were protected from contagion by capital controls. Measures in each of these countries deterred speculative attack without restricting capital flows for productive investments. Chile’s 30% one year reserve requirement had similar results. Even Malaysia’s dramatic restrictions on capital outflows, introduced in the wake of the crisis, hastened economic recovery. These cases demonstrate that government intervention in financial markets does not compromise productive investment and assures national sovereignty over monetary and economic policy.
A “market friendly” alternative to direct capital controls is the currency transactions tax, modeled after a proposal by Nobel-prize winning economist James Tobin in 1972. Tobin proposed that a small worldwide tariff (.5%) be levied by all major countries on all foreign exchange transactions in order to “throw some sand in the wheels” of speculative flows.
Over 80% of the global daily foreign exchange turnover is speculative transactions. These comprise round trip transactions of a week or less as banks, investment houses and hedge funds exploit small profit margins in stock, bond and currency markets. Tobin’s tax would automatically penalize the short-horizon exchanges, while negligibly affecting the incentives for commodity trading and long-term capital investments. A .2% tax on a round trip in another currency costs 48% a year if transacted every business day, 10% if every week, and 2.4 % every month. Productive investment would further benefit by reduced exchange rate risk and hedging costs.
An unintended benefit of Tobin’s original proposal was the enormous revenue that could be generated by the tax. Even with conservative tax rates, an estimated 33% percent shrinkage in global foreign exchange volume and additional reductions for exempted official trading and evasion, a phased-in currency transactions tax could generate between US$ 97-300 billion annually. In 1998, the United Nations Development Programme (UNDP) estimated that 40 billion US dollars a year for ten years would be enough to guarantee access to basic social services and adequate food, water and sanitation to every person on the planet. A coordinated multilateral system of redistribution of receipts from a currency transactions tax could eliminate the worst forms of poverty globally.
The remainder of this paper will examine the refinements of Tobin’s original proposal, now more commonly referred to as a “currency transactions tax”.
1.4 A Feasible Currency Transactions Tax – The Evolution of Tobin’s Original Proposal
Tobin’s original proposal raised a number of technical concerns associated with the difficulty of collection, evasion through asset migration or substitution, universality of application and effectiveness during times of crisis. Recent proposals by Schmidt (1999, 2000) and Spahn (1996) have made significant technical improvements on Tobin’s proposed methodology while remaining true to his concept.
Schmidt’s Foreign Exchange Payments Tax
Tobin’s original tax would have been applied to foreign exchange instruments at the point where deals are made in decentralized and unregulated markets. Collection and enforcement would be difficult and evasion likely. Canadian economist Rodney Schmidt proposes instead to tax the point at which the deals are “settled” .
Settlement is the last step in any foreign exchange transaction, the point where money changes hands between large banks. Domestic and international wholesale “payments” systems total and net transactions between and among major commercial and central banks for a final “settlement” or exchange of bank balances. In these payments systems, every financial transaction made by every bank is recorded. A tax applied to this structure, which is international, regulated and centralized, would therefore be administratively efficient. Further, the tax would be highly effective, as there would be limited potential for evasion by shifting the settlement of trades to other payments systems.
To understand the feasibility of Schmidt’s concept, it is necessary to clarify how currency is traded in the interbank market. In order to maintain control over the money supply, a central bank both issues currency and closely monitors the settlement of financial transactions involving its currency. To do so, the central bank allows only a limited number of large and reputable commercial banks to participate in the institutions that comprise the wholesale payments system. All other banks trading that currency must hold accounts with these “wholesalers”, also known as “correspondent” banks. Thus any bank in the world that wishes to buy or sell yen must have an account, directly or indirectly, with a Japanese correspondent bank that has an account with the central Bank of Japan.
All major trading banks in the interbank market make payments to each other, primarily in one of two ways. Banks conduct thousands of transactions with each other in branches around the world daily. Some of these transactions are settled directly through the domestic payments system of each of the two currencies involved. Some are totaled in offshore “netting” systems so that a net payment can be calculated and subsequently settled on the accounts of the correspondent banks mentioned above.
Around the world, systems to “settle” these transactions are becoming increasingly centralized and formalized as central and commercial banks work together to reduce and eliminate “settlement risk” – the risk of payment default. There are instances in which banks have collapsed because the two payments that constitute a single foreign exchange transaction were not settled simultaneously. Coordinated netting systems ensure that two parties pay each other at exactly the same time, regardless of timezone.
By 2001, domestic and netting payments systems will begin to be merged into one centralized global institution. The Continuous Linked Settlement (CLS) Bank, operating twenty-four hours/day, will create a one-stop global foreign exchange settlement institution. The CLS Bank will be linked to the domestic payments systems in all participating countries. Settlement risk will disappear. All transactions will be made electronically at just one institution regulated by the central banks of participating nations and linked to their own payments systems. The consortium of major commercial banks and G-10 central banks responsible for the creation of the CLS Bank are effectively establishing a transparent, centralized and accountable system ideal for taxing foreign exchange transactions. While existing systems would make the foreign exchange payments tax feasible, the CLS Bank would make tax collection potentially even easier.
Criticism that Tobin’s tax could be evaded by use of alternative financial instruments is invalid for Schmidt’s variant. All financial instruments, when exercised, are settled in the same way. If foreign exchange changes hands, it would be taxed under a foreign exchange payments tax regime.
The criticism that a currency transaction tax would require global adoption in order to function would simply not apply; the foreign exchange payments tax could be adopted unilaterally. The tax could be adopted by any government with the authority to tax. It would be placed on international exchanges of the domestic currency only and be implemented through the country’s domestic wholesale payments system by the central bank or by the new CLS Bank when it is operational. The tax would then automatically apply to every transaction involving the taxed currency, anywhere in the world.
To achieve the levels of revenue indicated in section 1.3 and the subsequent global developmental benefits associated with revenue redistribution, however, would require the participation more than one country. At present, 80% of all global foreign exchange transactions occur in seven centres around the world – London, New York, Tokyo, Hong Kong, Singapore, Frankfurt and Berne. Agreement by London, New York and Tokyo alone would capture 56% of the speculative trading and generate substantial revenue. A foreign exchange payments tax, adopted and collected nationally, with a portion of receipts redistributed through a multilateral treaty mechanism or institution, could help eliminate the worst forms of poverty and environmental degradation globally.
1.4.2 Responding to Crisis – Spahn’s Variant
Tobin’s original proposal was designed to prevent financial crises from occurring. During the Asian financial crisis, however, when currency values were plunging in excess of 40% and speculative profits were soaring, Tobin’s tax would have been simply too small to have had any effect.
In 1996, Paul-Bernd Spahn, a German economist, proposed a two-tiered variant which would provide a low tax rate (.01 to .02%) during “normal” market movements and a very high rate (50-100%) during times of financial crisis. The later tax was designed as a “circuit breaker” to halt trading of a currency when it falls sharply. This system is already in use in stock markets around the world. Knowing that their profits would disappear if a currency value changed too quickly, speculators would be less inclined to “attack” a currency. Spahn’s “circuit breaker” may never need to be used, as market participants, conscious of the penalty, would limit speculative activity.
Spahn’s “circuit breaker” tax would be particularly advantageous for small countries with limited currency reserves. Countries stockpile currency reserves in the event they are required to defend against speculative attacks. This strategy is becoming increasingly futile as global official reserves are now less than half a day’s turnover on foreign exchange markets. Not only can many countries no longer effectively defend their currencies, but, in attempting to do so, they immobilize increasing quantities of capital that could be used for development. By using a market mechanism to protect against speculative attack, reserve requirements could be reduced, liberating revenue for development.
Conclusion – The Way Forward
The revenues from the currency transactions tax represent a significant new source of public finance for world development. Given the declining commitment to bilateral and multilateral development assistance around the world, the tax could generate substantial resources to support environmentally and socially appropriate development globally. At a time when income disparity and social inequity are increasing, a currency transactions tax represents a rare opportunity to capture the enormous wealth of an untaxed sector and redirect it towards the public good.
The risk of future financial, economic and social crisis, coupled with the revenue potential for a currency transactions tax, are providing political incentives and opportunities for debate, analysis and support for such an initiative. In June, 2000, over 160 governments agreed to undertake a study on the feasibility of a currency transactions tax at the UN Social Summit in Geneva. In March, 1999, the Parliament of Canada passed a motion in support of a Tobin-type tax by a resounding 2:1 margin. It became the first parliament in the world to endorse the tax. Since then the French, United Kingdom, Brazilian and European Parliaments have held debates on the Tobin-type tax and over 400 Parliamentarians from around the world have signed the “World Parliamentarians Call for a Tobin Tax”.
Governments should undertake further studies on the appropriate administration, institutional frameworks and revenue redistribution options for the tax in order to further advance and inform the public debate. The UN High Level Panel on Financing for Development, announced in December 2000, provides one venue for such analysis. Multilateral fora, such as the UN’s Financing for Development process provide critical opportunities to foster political consensus and engage a broad range of actors and sectors to ensure the development and sustainability of currency transactions tax proposals.
The currency transactions tax is not a panacea for the world’s financial ills and developmental challenges. The global financial system must be fundamentally reformed to place people ahead of markets. Markets are not the best source of social regulation nor do capital and its returns constitute the ultimate criteria for defining value. The democratization of economic decision-making, the cancellation of developing country debt and the equitable redistribution of wealth must become the central principles upon which governments act in the new millennium. To accomplish these aims, a new global financial order is necessary. A currency transactions tax is one critical component of that new order.
BACKGROUND ON THE HALIFAX INITIATIVE
The Halifax Initiative is a Canadian coalition of fourteen environment, development, social justice and faith groups committed to the democratisation of economic decision-making as a means to achieve poverty eradication, environmental sustainability and an equitable redistribution of wealth.
The Halifax Initiative has been actively campaigning on the Tobin-type tax since the coalition was formed in 1994. The coalition advocated the use of the tax in the wake of the Mexican peso crisis and in the lead up to the 1995 Halifax G7 Summit. From the beginning, the coalition has worked to build a public and political constituency in support of the tax, both nationally and internationally.
The coalition achieved its most significant political victory when, on March 23, 1999, the Parliament of Canada became the first in the world to pass a motion on the Tobin Tax. The motion, “that in the opinion of the House, the government should enact a tax on financial transactions in concert with the international community,” passed by a resounding 2 to 1 margin, with all party support. Parliamentarians and the media recognized the significant role the coalition had played in raising public awareness and educating officials in the lead up to the vote.
The second significant achievement occurred at the Social Summit in June, 2000, as Canada led the successful proposal to undertake a UN-sponsored study on financing for development which will include research on the use of a currency transactions tax. One hundred and sixty governments supported the initiative.
Halifax Initiative is accredited to the UN through its member organization the Canadian Council for International Cooperation.
For more information please contact:
Felix, David. Foreign Policy in Focus. “Repairing the Global Financial Architecture – Painting over Cracks vs. Strengthening the Foundation”. September, 1999.
Bank for International Settlements, 1998 Survey.
Ul Haq, Mahbub. The Tobin Tax - Coping with Financial Volatility, Oxford University Press, 1996.p292. Based on 1995 Bank for International Settlements, New York Federal Reserve, IMF and Bank of England statistics.
In August, 1998, the Canadian, Australian and New Zealand dollar values plummeted as investors sought safe havens for capital withdrawn from Asia.
which together account for 82% of the work force.
For many large commercial banks, 1998 was a banner year, as increased volatility yielded spectacular returns. Deutche Bank reported a trading profit of US$ 595 million. According to Standard Chartered Bank’s 1998 Annual Report, “the result from Treasury was outstanding...their ability to continue trading, during periods of high volatility in the foreign exchange markets resulted in exceptional dealing profitability.” From Hayward, Helen. The Global Gamblers - British Banks and the Foreign Exchange Game. War on Want. 1998.p.2-3.
Ul Haq, Mahbub. The Tobin Tax - Coping with Financial Volatility, Oxford University Press, 1996.p4. Based on 1995 statistics provided by the Bank for International Settlements, Bank of England and the New York Federal Reserve.
Tobin, James. In Prologue to The Tobin Tax - Coping with Financial Volatility, Oxford University Press, 1996.p xi.
Felix,David. “On the Revenue Potential and Phasing in of the Tobin-type Tax” in UlHaq, Mahbub. The Tobin Tax - Coping with Financial Volatility. Oxford University Press. 1996.p236-243. Based on tax rates of between .05% and 25% on the major currencies and 1995 Bank for International Settlements (BIS) volumes (which were 26% lower than 1998 BIS figures). Estimates assume a 35% reduction in the tax base to account for exempted official trading and evasion.
"The cost of establishing and maintaining universal access to basic education, basic health care, adequate food, drinking water and sanitation, and for women, gynecological and obstetric care, is estimated at approximately 40 billion dollars a year." UNDP, 1998, p.33.
Schmidt, Rodney. “A Feasible Foreign Exchange Transactions Tax”. North-South Institute March, 1999. and “Efficient Capital Controls”. International Development Research Centre, Government of Canada. April 2000.
To retail or offshore payments systems.
Thus, Malaysia, can put a tax on the ringgit, but not on the US dollar.
BIS, April 1995.
Petrella, Ricardo. From Enroute. September 2000.