ON SEPTEMBER 2nd Italy became the first country in the world to extend its financial-transaction tax to high-frequency share trading. The Italian government hopes the tax will stabilise markets, reduce financial speculation and raise revenue for the government, as do ten other Eurozone countries considering similar policies. Such levies have been dubbed “Tobin taxes” after James Tobin (pictured), a Nobel Laureate in economics, who in 1972 first suggested taxing financial transactions. But do Tobin taxes actually work?
Tobin originally put forward his idea in a very different context to that faced by the Italian government today. He promoted it as a way of stabilising currency markets after the Bretton Woods system of fixed exchange rates collapsed in 1971. His proposed tax on currency exchanges was intended to curb de-stabilising capital flows across borders. Tobin envisaged a global tax, which was impossible to avoid by moving financial markets offshore. The proceeds would be donated to developing countries. But today Italy is implementing the tax on its own in a very different context. Its problems include a debt crisis, an uncompetitive economy and a weak banking sector, rather than exchange rate instability. The aim is not only to reduce stock market volatility, but to use the extra revenue to reduce Italy’s budget deficit.
The evidence to support Tobin taxes is thin on the ground, however. Most academic studies generally agree that they may not necessarily decrease volatility in financial markets. An experimental study in 2010 by researchers at the University of Innsbruck suggested that a global Tobin tax would have little impact on volatility. And there is not much evidence at all that unilateral Tobin taxes work. Although large markets might see a fall in volatility, smaller markets would see a rise due to a fall in liquidity. Even Barry Eichengreen, a supporter of Tobin’s original proposals, now argues that a European Tobin tax may prove a “distraction” that allows systemic risks and instability to increase in other areas. For instance, according to Harald Hau, an economist at the Swiss Finance Institute and the University of Geneva, “credit misallocation” in the economy as the result of distorting equity and bond prices may make life difficult for small and medium sized business that cannot raise finance from abroad. In practice Tobin taxes imposed unilaterally have proved unsuccessful as markets have moved abroad to avoid them. Sweden’s experiments in the 1980s with a transaction tax on shares, equity derivatives and fixed-income securities ended in failure as activity moved offshore to avoid the levies. In the first week of the fixed-income tax bond trading volumes fell by 85%; the amount eventually raised from the tax averaged only about 3% of what was predicted. By 1990 over 50% of Swedish equity trading had moved to London.
Similar difficulties may lurk in Italy. Il Sole, a financial daily, has reported that Italian traders are beginning to move their residency to Malta, which has excluded itself from any such proposed tax. This suggests that the Italian government may not raise as much revenue as it originally thought. However, by not extending the tax to bonds, the Italians have attempted to avoid the pitfall identified by the International Monetary Fund that a tax on trading government bonds might increase the cost of public borrowing. This would have been disastrous for Italy, a country faring badly in the European sovereign-debt crisis. But has it avoided all the potential adverse effects of the policy? Current academic opinion suggests that this is unlikely. The rest of Europe will no doubt be watching closely.
