The Robin Hood Tax

I wrote about the Tobin Tax for City AM back when Gordon Brown first brought it up in November. The scheme has been a favourite of anti-capitalist protesters and the radical Left for a long time, the Tobin Tax Initiative was set up in the United States in 1998. It promotes the tax as a way to "tame hot money and fund urgent global priorities."

Now it is being promoted under the faintly ridiculous title of "Robin Hood Tax" by a range of charities and, on Friday, Tory PPC and leader of the Conservative Group on Swansea Council René Kinzett on the ConservativeHome Platform.

The Tobin Tax has been adopted by people looking to do a number of things. Originally the plan was to curb fluctuations in exchange rates by preventing foreign exchange traders moving money around too fast. Then it was adopted as a way of funding various things like the United Nations. Most recently, it has become a way of getting money out of the financial services industry in retaliation for their incompetence leading to the financial crisis.

The original case for a Tobin Tax designed to restrain exchange rate fluctuations faded, and we stopped talking about the proposal for quite a long time, because worries about foreign exchange speculation have subsided. More countries have moved towards floating exchange rates. That means we get relatively fluid shifts in exchange rates rather than the dramatic movements that we saw in earlier years when speculators sensed that a peg such as the European Exchange Rate Mechanism (ERM) could not be maintained.

The most credible evidence suggests that Tobin Taxes tend to increase volatility in financial markets. The European Central Bank sets out why that can happen:

"Economic literature provides little evidence that a transaction tax such as the Tobin tax would reduce exchange rate volatility. In fact, the effect of such a tax on volatility is ambiguous, i.e. it could also increase volatility, as it may result in reduced depth and liquidity of the foreign exchange markets."

Empirical studies of the effect on volatility are often behind the academic firewall, but most of them find that a transaction tax increases volatility, at least in the short term (page 18 of this document).

The problem is that most advocates for the Tobin Tax have the mistaken view that trading and speculation are a bad thing. The truth is that trading helps the process of price discovery, makes markets work better, enhances liquidity, ensures that resources are priced correctly and generally helps oil the cogs of the global economy. Charles Goodhart, an economist at the LSE, sets out why there will be big problems if we impose a transaction tax on the foreign exchange markets, in particular:

"The Tobin tax is a bad idea, since it would greatly increase both the costs and volatility of foreign exchange dealing and throw a huge spanner into the workings of the global financial economic system. The proponents of the Tobin tax mistake the fact that commercial end-use of foreign exchange (fx) dealing is not more than about 10%, at most, of the total of fx transactions into a belief that the other 90% is a form of ‘socially useless’ speculative froth, which could, and should, decline without real loss. This latter viewpoint is just wrong. Taking an unhedged, open fx position is risky, and, hence, bank market makers are not allowed to do so, beyond limits. So any new commercial order unbalances a market maker’s initial position, almost forcing him to rebalance by trading out of his new position with another market maker. The ‘hot potato’ will pass from hand to hand until prices and quantities eventually adjust to a new equilibrium.
Essentially a Tobin tax imposes much greater costs , even if it seems proportionately low, because the margins on which the market makers are operating are low.  The costs of transacting out of an unbalanced position would rise sharply, and with it the bid-ask spread on fx deals, liquidity would disappear and fx volatility would be enhanced.  Meanwhile speculators, betting on a significant change in the asset/currency price, would not be much deterred by a small increase in transaction costs."

So the Tobin Tax fails to deliver on its original objectives.  But for some time, well before the financial crisis, it has also been seen as a means of funding various things.  The Tobin Tax Initiative I mentioned earlier see it as a way to "meet urgent global priorities, such as preventing global warming, disease, and poverty."  The new "Robin Hood Tax" campaign argued that a transaction tax would "give billions to tackle poverty and climate change, here and abroad."

The problem is that the Tobin Tax, as it was designed to change behaviour, is an incredibly inefficient way of raising revenue.  An efficient tax is one that takes relatively little time, effort and money to collect and enforce and that is relatively hard to avoid.  The Tobin Tax fails on both counts.  Again, the basic problem is set out by Charles Goodhart:

"The Tobin tax – a tax on financial trasactions - is not efficient as exchange operations can be easily done anywhere in the world."

Of course, collecting the tax would be relatively cheap.  It could be collected at the exchanges through their systems.  But the bigger challenge and expense is the process of putting in place and enforcing a global tax.  If the tax wasn't global, it would just give a big competitive advantage to tax havens.  The tax would be completely unworkable if a major financial centre wasn't included, and it seems unlikely that the Chinese - and therefore Hong Kong - will play ball.  Doing anything at a global level is monstrously difficult, as the failed and expensive negotiations over a climate change deal at Copenhagen show.  Enforcing it would also be a diplomatic nightmare; what if we don't think Dubai is properly enforcing the tax?

Ordinary taxpayers will pay an even heavier price in the long term if we let politicians establish an international tax cartel.  There will be nowhere to run when a global government puts in place bad policies, and that major pressure to keep down the burden imposed on families and businesses will be undermined.

The tax is also easy to avoid.  Economist James Tobin initially proposed it as a one per cent tax on short term currency trades. Since then, the proposed rate has fallen, most proposals now suggest about 0.1-0.2 per cent, but the scope has been expanded to include other transactions; because otherwise the tax can easily be avoided by trading via other cash-equivalent derivatives.  But the advocates for a Robin Hood tax want it to only apply to certain types of transaction as well:

"The tax will apply only to wholesale, not retail financial transactions.  So you won’t pay it when you change money on holiday, or nip into your local bank or building society."

That distinction is going to be far easier to apply in theory than in practice; there will be big grey areas.  And even if you only apply the tax to wholesale transactions the cost will likely be passed on to retail markets.  Increase the cost of supplying banking services and you'll push up the price paid by ordinary consumers and businesses.

That's why the tax fails on the final objective, getting some restitution for the bailout that taxpayers had to provide to the sector in the financial crisis.  We'll still be facing all the consequences of the financial crisis, we'll just also be paying more to the banks so that they can pay the new tax and fund wasteful international aid and climate change spending.

Instead of looking for new ways of paying for bailouts, we should be looking at how we can avoid the need for them in the first place. Before the recent crisis, the last serious deposit bank failures in Britain were in 1878, when the City of Glasgow Bank and the West of England & South Wales District Bank failed. The idea that we should give up on the stability of the British banking system, when it was maintained through an entire century of wars and depressions, is absurdly defeatist.

A Tobin Tax doesn’t address the causes of the financial and economic crisis. Its root cause was simply that too many big banks were too exposed to unreliable mortgage loans. When a housing bubble in the United States burst, those banks got into huge trouble and taxpayers’ money was used on an incredible scale to keep many of them afloat. Reducing the number of financial transactions at any point wouldn’t have changed anything (and many mortgage CDOs were held for long periods, not constantly traded).

If Brown were serious about protecting ordinary people, he would start asking serious questions about whether there were any policies that drove the previously quite stable British banking system to need a bailout from the taxpayer. There are a number of ways in which government action made matters worse.

In the build-up to the crisis policy often encouraged banks to take more risks. Low interest rates, in particular, encouraged both more borrowing and riskier lending. Regulation and activism in the United States promoted subprime lending. Even the housing bubble itself cannot be separated from policy decisions, as strict planning regulations make the supply of housing more inelastic and mean changes in demand are almost entirely reflected in prices.

Once the crisis got underway, regulators performed poorly and made matters worse once again. The Bank of England complained that it was unable to support Northern Rock covertly thanks to EU rules. There were clearly problems at the Financial Services Authority and the Bank of England has been described as “flying blind” with the tripartite system leaving it bereft of the detailed information on individual banks needed to maintain financial stability.

Finally, regulations exacerbated the crisis. As far back as 2004, a study for the Board of Governors of the US Federal Reserve System had warned that Basel II’s capital requirements would be procyclical. And, during the crisis, mark to market accounting regulations became deeply counter-productive: every one of the United States’ ten largest banks would have become insolvent in the 1980s had mark to market been in place at the time.  Restrictions on short selling hurt hedge funds and prevented them from playing a part in limiting the crisis.

Politicians should be looking at these issues, and trying to reform policy to reduce systemic risk. Working out how to pay for financial busts is a poor substitute for avoiding them.

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