Tobin Taxes

I believe that I became interested in finance for the first while reading something about the Tobin tax when I was a teenager.  The idea was being pitched through a new organisation called attac.  I sort of forgot all about it while completing university, but the topic came up once in a seminar in financial engineering that I took in grad school.  The guy’s point was that it was completely unfeasible.

Anyways, via Justin Fox, I learn that the new head of the FSA brought up the subject during an interview with Prospect Magazine.  It did not take long for people to start freaking out;

Bankers, industrialists and London’s mayor have fiercely rejected Lord Turner’s argument that Britain’s “swollen” banking industry was destabilising the economy and needed to be cut down to size.

The backlash came a day after the chairman of the Financial Services Authority said the City watchdog should be “very, very wary of seeing the competitiveness of London as a major aim”.

He also floated the idea of higher capital reserve requirements and a global Tobin tax on financial transactions to choke off some of the banks’ “socially useless” activity.

Lord Turner’s critics said he had overstepped his remit as a regulator and risked damaging London’s standing as Europe’s leading financial centre.

Clearly the usual suspects will be objecting.  You cannot really expect bankers to be in favour of something that will cut into their revenues.  But what about the actual merits?

Stephen Gordon, an economics professor at Laval University in Quebec City, said he failed to see how taxing financial transactions would have prevented the financial crisis, which he attributes to excessive leverage and poor risk management. Prof. Gordon also pointed out that such a tax would have exacerbated the credit crunch by making capital even more expensive.

But the biggest knock against the Tobin Tax is rooted in pragmatism: All the world’s big economies would have to institute it to keep banks from simply doing business in jurisdictions that refused to apply the levy.

And probably this is right.  I don’t believe that the idea is a bad one, but it is probably not feasible in practice for 2 sets of reasons.  First, it would require international cooperation/coordination on scale never seen before.  Secondly, financial engineering would make evading taxes fairly easy, unless the regime was set-up in an incredibly complex way as to capture trades that replicate spot fx trades.  For a good explanation, I dug up an old paper from the federal reserve bank of San Francisco:

The second enforceability problem relates to the definition of the tax base. That is, how exactly is a foreign exchange transaction to be defined? Modern financial engineering is based on replicating one asset with combinations of other assets. At a minimum, the tax would have to be applied to forward, futures, and swap transactions in addition to spot transactions, since a spot transaction can be replicated easily by a combination of debt and forwards, futures, or swaps. In fact, the problem is even worse than this. Spot transactions could also be approximated by exchanging liquid securities (like T-Bills) denominated in different currencies.  Consequently, the tax would likely spread and eventually come to envelop large segments of what is traditionally regarded as the domestic capital market. This problem, more than any other, would likely kill the Tobin tax.