ATTAC - Taxing International Short Term Capital Flows

Summary

Interest in the potential for taxing international capital flows stems from concern that exchange rates under floating rate regimes are too volatile, and that exchange rate target zones are too vulnerable to real shocks or inconsistent macroeconomic policies. A contributing factor in both cases is the rapid development of capital mobility in the last decade, deriving from capital market liberalisation and technological innovation. Taxes on foreign exchange transactions are therefore intended to reduce the volatility of international short term capital flows. They would do so by raising transactions costs and creating a wedge between short term domestic and foreign interest rates. This should reduce the speed of adjustment of international financial markets to shocks, reduce excessive exchange rate volatility, and increase domestic policy independence in the short term.

We outline three proposals for taxing international short term capital flows. We present the case for such taxes, and discuss the practical implications of tax evasion. We conclude that, except in very restricted circumstances, taxes on international short term capital flows would not be effective and would impose high costs on domestic financial markets.

A devastating practical problem with taxing international short term capital flows concerns tax evasion and flight of trading activity from domestic to international financial markets. Unless a world-wide uniform tax is imposed on all instruments for transacting in foreign currency, the tax will be largely ineffective. Unilateral domestic imposition of the tax can only work in the very short term, say to counter an immediate attack on a targeted exchange rate, if applied on an ad hoc and temporary basis. Even so, the cost to the domestic financial sector may be high.

Interest in the potential for taxing international capital flows stems from concern that exchange rates under floating regimes are too volatile, and that exchange rate target zones are too vulnerable to real shocks or inconsistent macroeconomic policies. A contributing factor in both cases is the rapid development of capital mobility in the last decade, deriving from capital markets liberalisation and technological innovation. We now have highly integrated global capital market in which huge volumes of capital can be moved at short notice. Turnover in the global foreign exchange market was about US $ 1,000 billion per day in 1992, just before the collapse of the European Exchange Rate Mechanism (ERM). This is about triple the amount transacted daily in 1986. In comparison, the foreign exchange reserves of the combined central banks of the G10 countries in 1992 were about US $ 400 billion (Bank for International Settlements, 1993; Goldstein, 1993). This implies that central banks cannot counteract for long broad-based market movement by intervening in foreign exchange markets.

In this note we outline three proposals for taxing international short term capital flows. We present the case for such taxes, and discuss the practical implications of tax evasion. We conclude that, except, in very restricted circumstances, taxes on international short term capital flows would not be effective and would impose high costs on domestic financial markets.

Proposals for taxing international capital flows include : 1) a proportional tax on currency conversions (Tobin, 1978) ; 2) a real interest rate equalisation tax (Laviatan, 1980 ; Dornbusch, 1986) ; and 3) deposit requirements for institutions trading in foreign currency (Eichengreen and Wyplosz, 1993). These proposals are designed to tax large, short term or round trip foreign exchange transactions more heavily than small, one way or long term transactions. The first two proposed taxes are open and explicit ; the last is implicit. The first tax increases directly with the size of the transaction ; taxes paid under the other two schemes depend on financial market conditions as well as the size of the transaction. All three taxes are intended to reduce the volatility of short term capital flows by raising transaction costs.

The original proposal by James Tobin for taxing international capital flows was for a moderate proportional tax on all conversions of one currency into another. Such a tax would affect short term capital flows the most. For example, a one per cent tax on a round trip foreign exchange transaction would permit an annualised domestic-foreign interest rate differential of 24 percentage points on a one month time horizon, 8 points on a 3 month horizon, 2 points on a one year horizon. Because of the inevitable attempts to evade such a tax, it would have to be applied as broadly as possible : world-wide and to all types of foreign exchange transactions and instruments.

This would be a tax on differences in the real interest rates across countries. The tax base is the size of the foreign exchange transaction. The tax rate is the discrepancy between the percentage change in the nominal exchange rate and the difference in inflation rates ; that is, the deviation in international purchasing power parity (PPP). Such a tax equates nominal interest and inflation rate differentials, and thus real interest rates. Short term capital flows are taxed more heavily than long term flows as long as the deviation from PPP are not permanent.

This would be an implicit tax on institutions trading in foreign exchange. It would require financial institutions purchasing foreign exchange to make non-interest-bearing deposits with the central bank. Deposit might, for example, be equivalent to the amount transacted and held one year (this scheme was introduced in Spain during the ERM crisis in September 1992, but dropped within weeks). The tax would be equivalent to forgone interest earnings and would therefore increase with the interest rate. It would have greatest effect during periods of exchange market crisis, since interest rates rise under such circumstances.

Taxes on international short term capital flows are pertinent to both flexible and target zone rate regimes. Policy or other shocks arising in foreign countries are transmitted to the domestic economy under both regimes, although the channels of transmission and impact of the shock are different. Under a flexible regime the exchange rate is determined by international capital flows as well as current account transactions. Thus, even a flexible exchange rate does not continuously balance the current account by absorbing the effects of foreign policy changes. Under a target zone the exchange rate is not allowed to adjust fully to absorb foreign disturbances. Rather, domestic policies and the rate balance must adjust to achieve the exchange rate objective. If policies or the trade balance are not adjust, the resulting macroeconomic disequilibrium will inevitably end in a realignment of exchange rate targets, in either an orderly or disorderly fashion.

Taxes on international short term capital flows should be considered if they will reduce the volatility of exchange rates under a flexible rate regime, or the volatility of foreign exchange market under a target zone regime, without imposing unacceptable costs on domestic banking system. This section examines whether there is, in principle, a role for taxes under flexible and target zone exchange rate regimes. We find that there is a case for taxes under a flexible exchange rate regime, but that the case for taxes under a target zone exchange rate regime is weak. We leave the question of the practical impact of such taxes for a later section.

Since the move to generalised floating in the early 1970s, exchange rates have displayed large, extended, and often subsequently reversed swings. In some cases, the pattern, if not the magnitude, of these movements can be explained by conflicting mixes of monetary and fiscal policy between countries. In other cases, however, exchange rates have moved in opposition to trends suggested by fundamental variables. Short term movements in exchange rates are almost totally unpredictable, bearing no systematic relationship to fundamental variables (Dornbush, 1986 ; Dornbusch and Frankel, 1987).

There are two senses in which flexible exchange rates may be too volatile. First, exchange rates can be fully consistent with fundamental economic variables, such as relative prices and macroeconomic policies, while still responding excessively to shocks to those variables before adjusting gradually to new long term equilibrium levels. Such exchange rate ‘overshooting’ may occur because international capital markets adjust almost instantaneously to shocks, while goods and services markets adjust slowly (Dornbusch, 1976). While predictable, this type of exchange rate volatility is costly since it amplifies the domestic impact of disturbances arising in foreign markets, exacerbating fluctuations in domestic growth and unemployment.

Second, flexible exchange rates may be too volatile if they are primarily influenced by factors unrelated to fundamental economic variables. In this case, exchange rate movements would be largely unpredictable, especially in the short term. Furthermore, the short term independence of exchange rates from fundamental variables can lead to long term exchange rate misalignment, in the sense, once again, that long term exchange rates do not reflect underlying relative prices and macroeconomic policies. Excess volatility and misalignment of long term exchange rates car occur for the following reasons : 1) Exchange rate expectations may not be rational. Surveys of market traders in foreign exchange indicate that most put more emphasis on extrapolating trends in exchange rates than on forecasting fundamental variables ; 2) Exchange rate expectations may not be homogeneous. The enormous volume of trading in foreign exchange markets indicates that different traders have different expectations for the future path and variability of exchange rates ; and 3) Even if rational and homogeneous, exchange rate expectations may not be consistent with fundamental economic variables. The best model of exchange rates that we have is the random walk or near-random walk, which posits no systematic relationship between short term movements in exchange rates and fundamental variables. This means that rational traders base forecasts of the future exchange rate on the current spot rate, rather than on the expected long term equilibrium rate.

Given these sources of excessive volatility of flexible exchange rates, there are two circumstances in which taxes on international capital flows may be considered. First, if flexible exchange rates respond primarily to fundamental economic variables, then reasonable macroeconomic policies and informal co-ordination will reduce the volatility of exchange rate movements. If, however, international co-ordination of macroeconomic policies fails, then taxes on international capital flows may be considered. Second, if flexible exchange rates respond primarily to forces unrelated to fundamental variables, then taxes may potentially reduce these fluctuations.

The recent collapse of the ERM exposed the vulnerability of target zone exchange rate regimes to conflicts in fundamental economic variables (Svensson, 1993). One source of the collapse was differing inflation rates in participating countries, resulting in diverging real exchange rates. Another source was a series of real shocks affecting some countries more than others, requiring a real exchange rate adjustment. The most significant of these was the German fiscal expansion following unification. Given these underlying inconsistencies, the timing of the collapse seems to have been affected by uncertainty over the adoption of the Maastricht Treaty in Denmark and France. This uncertainty raised the possibility that political support for the commitment to macroeconomic policy convergence was weak.

In general, with a high degree of international capital mobility, the tolerance of exchange rate target zones for inconsistent fundamental economic variables is limited. One reason is that there may not be time for the disciplining mechanism inherent in a fixed exchange rate system to work. For example, a rising real exchange rate, possibly due to a domestic inflation rate that is higher than the foreign inflation rate, will normally lead to a deterioration in the trade balance. This induces a domestic recession, which eventually restrains domestic inflation and slows or reverses the rise in the real exchange rate. An attack on the exchange rate target, which may be precipitated by expectations of insufficient political support for a recession, would short the process. Furthermore, once a concerned attack on a target is underway, it is impossible to resist. The combination of massive resources, high potential profits, and low risk (since speculators lose little if the regime survives) is unbearable. The cost of even short term resistance, in terms of high domestic interest rates and central bank foreign currency losses, can be enormous.

For these reasons, taxes on international capital flows cannot protect an exchange rate target zone from collapse when there are asymmetric real shocks and macroeconomic policies are inconsistent. The most that can be hoped for is that they will marginally reduce the domestic costs of resisting an incipient attack, so as to gain time for an orderly realignment.

This section examines the practical effectiveness of taxes on international short term capital flows, and their impacts on domestic financial markets. We begin by summarising the objectives of taxes. We then consider whether taxes will achieve those objectives in practice. We conclude that the potential to evade taxes severely restricts the circumstances under which they can be made to work as intended.

Taxes on foreign exchange transactions are intended to reduce the volatility of international short term capital flows. They do so by raising transactions costs and creating a wedge between short term domestic and foreign interest rates. This should reduce the speed of adjustment of international financial markets to shocks, reduce excessive exchange rate volatility, and increase domestic policy independence in the short term.

A devastating practical problem with taxing international short term capital flows concerns tax evasion and flight of trading activity from domestic to international financial markets. Unless a world-wide uniform tax is imposed on all instruments for transacting in foreign currency, the tax will be largely ineffective. Given the importance of international financial centres in Singapore and Hong Kong, for example, even a coordinated tax by the G10 countries will not be effective. Unilateral domestic imposition of the tax can only work in the very short term, say to counter an immediate attack on a targeted exchange rate, if applied on an ad hoc and temporary basis. Even so, the cost to the domestic financial sector may be unacceptably high. For example, Spain imposed foreign exchange deposit requirements on resident financial institutions during the ERM crisis in September 1992, only to remove most of them nine days later, citing "unintended side effects".

In the current debate over reform of the international monetary system, promoted by the fiftieth anniversary of the Bretton Woods institutions, a proposal for an internationally coordinated tax on short term capital flows would be relevant. However, the prospects for success are dim. There remains widespread unease about deliberately retreating from international economic integration, especially in international capital markets. Following the ERM crisis, a suggestion by Mr Jacques Delors, Chairman of the European Commission, to reintroduce capital controls in Europe was quickly suppressed.

There is general disillusion with the current operation of both flexible and target zone exchange rate regimes. Both fail to insulate the domestic economy from international disturbances. On the contrary, given the different response rates of financial and goods and services markets, both arrangements actually magnify the effect of international disturbances on the domestic economy. Moreover, neither arrangement is capable of dealing effectively with the recent rapid rise in international short term capital mobility. Flexible exchange rates may be too volatile, and targeted exchange rates too vulnerable.

In this note we have outlined three variants of a tax designed to reduce the volatility of short term capital flows, without unduly affecting the mobility of long term resources. We have found that, in principle, such a tax would be best suited as a supplement in a flexible exchange rate regime, although it may also be useful in the context of an exchange rate target zone crisis.

We have also found that the potential to evade taxes, either by shifting the jurisdiction under which currency is exchanged or by developing new financial instruments, severely restricts the circumstances in which a tax on capital flows will work. The tax will be most effective it is applied internationally and uniformly on all instruments for transacting in foreign currency. It may also be effective in the very short term if it is applied unilaterally and temporarily in urgent situations, such as during an attack on an exchange rate target. In the latter case, there may be substantial capital flight from domestic financial institutions.

Taxing International Short Term Capital Flows

Rodney SCHMIDT. International Economic Analysts.

Rodney SCHMIDT.
International Economic Analysts.