Taxing the banks: can it work in practice?

Inclusive Economy30 Jun 2011Neil McCulloch

Today, the Institute of Development Studies is launching the results of the first systematic review of the evidence relating to taxes on financial transactions. Financial Transaction Taxes (FTTs) have been in the media spotlight over the last few months, as policy makers around the world have searched for ways of plugging budget deficits. These Financial Transaction Taxes (FTTs) or Tobin Taxes, work by levying a small tax, perhaps 0.005%, on banks’ and traders’ financial transactions (see the The Broker for details).

But the idea is hotly contested. On the one hand, activists such as the Robin Hood Tax campaign argue the moral case for making the bankers pay for the damage caused by the financial crisis and hope the revenue could be used to fund global anti-poverty and climate change initiatives. European politicians have added their support to these campaigns, ahead of the publication of the EU Impact Assessment of FTTs. On the other hand, financial experts argue that a tax on financial transactions would be very difficult to implement or enforce and so would neither calm markets nor raise significant revenue

In conducting our Systematic Review, we wanted to move away from politically-charged debates, and find out what the available evidence actually says about FTTs. We therefore compiled a list of almost 500 papers that have been written about such taxes and attempted to identify what facts we have good evidence for, and what we do not. We found good evidence for three things.

First, contrary to the complaints of the financial sector, it is clear that these taxes are feasible. Several countries already have FTTs on shares; taxing foreign exchange is trickier – but it is already being done in Brazil, and new centralised mechanisms for settling transactions make it easier for countries to implement these currency transaction taxes too. However, getting the design of the tax right is crucial. For example, the tax does have to be applied to a broad range of financial instruments to avoid market actors simply shifting from taxed financial instruments to untaxed ones. Similarly, one has to tax something over which there is a legal monopoly to ensure that transactions don’t simply migrate to untaxed jurisdictions.

Second, although there are lots of theoretical models that suggest that such a tax should dampen down volatility in the markets, studies of actual markets suggest, if anything, the reverse i.e. that FTTs might increase volatility. This is a pity – one of the original rationales for the tax was to calm markets. However, the effect is small – overall it appears that if FTTs are appropriately designed, they are unlikely to have much effect on market volatility either way.

Finally, on the issue of how much these taxes would collect – the numbers are big, even when you take into account the reduction in trade as a result of the tax. We find that applying a 0.005% tax to foreign exchange markets alone might raise around $25 billion per year worldwide. If you include equity markets, derivatives and the Over the Counter market, the sums become very large indeed.

Given the evidence, what should be done? At today’s event in Brussels, representatives from NGOs, academia, the financial sector and policy makers are going to be debating exactly this question. I’ll be reporting back later this week on what they came up with.