Tax the rich and give money to the poor – that’s the basis of fiscal policy being put forward by the UK Labour Party’s new shadow chancellor, John McDonnell. As well as forcing large corporations to pay their “fair share”, the idea of the Robin Hood – or Tobin – tax has been resurrected. But what actually is it and how would it work?
The Tobin tax was originally suggested as a tax on all foreign currency exchange payments. Proposed by economist James Tobin in the 1970s, the idea was motivated by the need to curb massive and destabilising movements of funds between different currencies when the Bretton Woods system of fixed exchange rates was replaced by a volatile flexible exchange rate regime. It has since been extended to cover financial transactions such as stocks, bonds and derivatives.
Underlying the idea of the Tobin tax, there is a clear principle of discouraging short-term currency speculation. With flexible exchange rates and global interest rate differentials, countries incur unrecoverable economic costs in managing their monetary policies when exchanging currencies. These costs grow in the presence of short-term currency speculation, which is encouraged by the nature of the free currency market.
To work effectively, Tobin said it would have to be an internationally agreed uniform tax, to prevent countries moving their markets elsewhere. So far, the idea has traction in 11 European countries and the European Commission, but not the UK or the US
Although Tobin suggested a rate of 0.5%, other economists have put forward rates ranging from 0.1% to 1%. Even at a low rate, if the tax were put on every financial transaction taking place globally, it could raise billions in revenue.
In theory, the primary advantage of the tax is that it could be a source of revenue for governments, which could assist them in tackling debt levels. The tax is fair, as it is paid by banks and financial institutions that are profiting from market volatility. Advocates point out that it is only fair that banks and the financial industry help pay off the debts that many of them helped increase when they were bailed out following the financial crisis.
The tax, in principle, also helps to increase stability. It cushions the domestic economy against adverse speculative risks in foreign currency transactions, which in turn lowers the possibility of frequent and harmful changes in monetary policy. For instance in the 1990s the existence of a Tobin tax could have prevented countries such as Russia and Mexico having to raise their interest rates to very high levels, as their currencies came under threat from speculators.
However – and given the current state of global financial markets – the Tobin tax is likely to discourage the volume of financial transactions taking place. This would have seriously harmful effects on economic growth. It would also result in job losses in financial centres and decline in the level and flow of foreign direct investment. This would slow global economic growth and development in the long run. Thus, many in the UK oppose the tax, for fears it would hurt the City of London, which forms a significant part of the UK economy.
There are also fears that the cost of the tax to banks could be passed on to customers. This could take the form of increased fees, lower long-term rates, greater spread between lending and borrowing rates, or higher service charges. This would all result in lesser real returns from long-term savings (such as pensions), a crowding-out effect in investment and lower growth in the domestic economy.
Critics also argue that since private information in financial markets makes it difficult to distinguish between fair trading under normal liquidity and speculative trading, a global Tobin tax would actually do little to decrease volatility on a global scale. If the tax is applied at high rates, it will severely weaken financial operations and create international liquidity problems. A lower tax rate, on the other hand, may reduce the negative impact on financial markets but will fail to restrict speculation where expectations of an exchange rate change exceed the tax margin. While this may lead to a fall in volatility in relatively larger markets, smaller markets would see a rise in volatility due to a fall in liquidity.
But given the extent of globalisation and the integration of financial markets, advocates of the Tobin tax argue that it could raise billions of pounds even if it was imposed at a very low rate on all financial transactions across the world. Though revenues were less than expected when the tax was used in Sweden in the 1980s (and scrapped after seven years), equivalents are still used in some of the world’s fastest-growing financial centres, including Hong Kong, Mumbai, Seoul and Johannesburg, where they are said to collectively raise £12 billion a year.