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Tobin tax leaves a bad taste

The introduction of a Tobin Tax to fund the European budget would leave a bitter taste, warns Peter O’Kelly

27 Jul 2011

By Peter O'Kelly, EDHEC-Risk Institute

Concept image of man with a bad taste in his mouth

IN ITS BUDGET proposal for the period 2014-2020, the European Commission (EC) has included a levy on financial transactions, more commonly known as a Tobin tax. The text, which was presented by the president José Manuel Barroso on 29 June, envisages the introduction of this tax to fund about a third of its overall budget.

The tax was originally proposed by the US economist James Tobin in the 1970s as a tool to combat financial speculation, but has never been implemented. The intention is for it to contribute €50bn per year to the European budget, or €350bn over the seven-year period. It will amount to 0.01% of derivatives trades and up to 0.1% on exchanges of sovereign bonds. Foreign-exchange transactions will also be concerned.

The levy on financial transactions is the subject of differing positions from the member states. Germany, France, Spain and other countries are in favour of it. Members of the French National Assembly even voted for a European resolution to introduce this tax on 14 June.

The UK, on the other hand, is firmly opposed to this project. It is believed that it will lead to financial activity being transferred from the City towards Asia or Switzerland. Moreover, the British Bankers' Association warns that such a tax will be paid by bank customers rather than the banks themselves.

EDHEC-Risk Institute's research, published in July, shows that the theoretical arguments in support of the Tobin tax as a measure to reduce volatility are, at best, mixed. The Tobin tax will obviously lead to a reduction in the trading of securities on which the tax is imposed and will reduce speculative activity in financial markets. However, this tax also drives away investors who provide liquidity, stabilise prices, and help in the price discovery process.

The empirical evidence, on the other hand, indicates that a Tobin tax either has no effect on volatility or actually increases volatility. The imposition of a transaction tax leads to a reduction in the demand for that financial security and, thus, a drop in its price.

Introducing a Tobin tax will bring serious implementation challenges. Can regulators really distinguish between transactions related to fundamental business and those that are purely speculative? Can regulators determine the appropriate rate for the Tobin tax – one that will reduce the activities of investors who are not fully rational without driving away trade by rational investors? And, unless every country in the world introduced the Tobin tax, it will be easy to circumvent the tax by routing transactions through countries that do not impose the tax.

While free financial markets may not be the best solution, a Tobin tax is unlikely to be the correct medicine for the negative effects that arise from trading in financial markets by investors who are not fully rational.

Peter O'Kelly is marketing and communications manager at EDHEC-Risk Institute

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