Is a Financial Transaction Tax a Good Idea? A Review of the Evidence

The Institute of Development Studies has undertaken a comprehensive review of the feasibility of financial transaction taxes (FTTs). We find that, worldwide, a financial transaction tax on foreign exchange transactions could raise US$26 billion. In the UK alone it could raise US$11 billion (£7.7 billion), roughly the same as the entire UK aid budget. Such a tax would be most effective if implemented by the key financial centres around the world, but a currency transaction tax could be implemented by individual countries. However, an FTT is unlikely to reduce market volatility as claimed by some campaigners. We recommend that the UK Government designs and implements an FTT on sterling transactions and explores the possibility of coordinating the introduction of similar FTTs with the governments of other major financial centres on their own currencies.

In 1978, the Nobel Prize Laureate in Economics James Tobin proposed to ‘throw some sand in the wheels of our excessively efficient international money markets’, by levying a small tax on all foreign exchange transactions in order to penalise short-term speculators but not long-term investors. The idea was that discouraging speculative behaviour would stabilise markets. Ever since, the issue of the ‘Tobin Tax’ (and other similar FTTs) has generated emotive debate. On the one hand, many economists share an instinctive dislike for taxing transactions and most working in the financial sector regard it as unworkable or naïve. On the other hand, campaigning groups, such as The Robin Hood Tax campaign, many politicians and some economists propose FTTs in reaction to major financial crises.

Policy implications snapshot

The UK Government should:
·    Design and implement a currency transaction tax on sterling;
·    Monitor the implementation of this new tax;
·    Coordinate with policy makers in other financial centres with a view to encouraging a similar tax in the Euro zone and in the US;
·    Study the feasibility of a broader FTT to include derivative and over-the-counter (OTC) markets, in coordination with other major financial centres.

Policy Implications
In an environment in which the governments of most of the world’s financial centres are faced with making large spending cuts, the existence of a significant source of currently untapped revenue is important. Although the evidence is not conclusive on all points, it seems clear that an FTT is implementable and could make a significant contribution to revenue in the major financial economies. It seems unlikely that it would stabilise financial markets but, if appropriately designed, it is unlikely to destabilise them either. Although a multilateral agreement between the key economies is clearly preferable, it would not be impossible to implement unilaterally, at least for a major economy. The incidence of such a tax would not be as progressive as some of its proponents claim, but we have no reason to believe that it would be significantly worse than most alternatives, nor that it would be any more difficult to collect.

The UK Government should:
1.    Design and implement a currency transaction tax on sterling: The logical first step would be to design and implement an FTT on sterling transactions, since settlement of these transactions is under the direct control of the UK authorities.
2.    Monitor implementation of the tax: Even if well designed, a new tax of this kind is likely to give rise to avoidance. It is therefore important that the implementation of the tax is closely monitored and the design adjusted to minimise opportunities for avoidance.
3.    Coordinate with policy makers in other financial centres: A tax on sterling will raise revenue, but it will also disadvantage sterling relative to other currencies. It will therefore be important for the UK to coordinate policy with other countries, with a view to encouraging the application of a similar tax in the Euro zone and in the US.
4.    Study the feasibility of a broader FTT: If the currency transaction tax is successful, it would then be sensible for the Government to study the feasibility and revenue potential of broadening the FTT to include derivative and OTC markets, in coordination with other major financial centres.

Further reading:
Aliber, R.Z., Chowdhry, B. and Yan, S. (2003) ‘Some Evidence That a Tobin Tax on Foreign Exchange Transactions May Increase Volatility’, European Finance Review 7: 481-510
Spratt, S. (2005) A Sterling Solution. Implementing a Stamp Duty on Sterling to Finance International Development.: Intelligence Capital Limited, Stamp Out Poverty
Umlauf, S. R. (1993). ‘Transaction taxes and the behavior of the Swedish stock market.’ Journal of Financial Economics 33(2): 227-240.
Leading Group  (2010), ‘Globalising Solidarity: The Case for Financial Levies’, Report of the Committee of Experts to the Taskforce on International Financial Transactions and Development of the Leading Group on Innovative Financing for Development.  July 2010.

Credits:
This In Focus Policy Briefing was written by Neil McCulloch,
a Research Fellow in the Globalisation Team at IDS, and Grazia Pacillo at the University of Sussex. It was edited by Sarah Nelson and James Georgalakis.
The opinions expressed are those of the authors and do not necessarily reflect the views of IDS or any of our funding partners.
Readers are encouraged to quote and reproduce material from issues of In Focus Policy Briefing in their own publications. In return, IDS requests due acknowledgement and quotes to be referenced as above.
© Institute of Development Studies 2010 ISSN 1479-974X