Tobin Tax: Dealing with exchange rate arbitrage

Well I sincerely confess that before last month I hadn't ever heard about this new (well not theoretically) variant of tax; Tobin Tax. But now I think I have sufficient grasp of its ingredients that I feel it is required to be known (if not understood in technicality, which in fact is not very complex) by almost all those who have heard or known about exchange rates. So I contribute this post to common knowledge, just in line with the ideology of this blog.

Proposed by James Tobin (an economist), this tax is based upon the premises that exchange rates between the various currencies are susceptible to abuse at the hands of those who seek to take advantage of the floating rates and make profits out of the arbitrage which they get from the buying and selling of currencies at different rates. To counter such tendencies and also to ensure a degree of stability in exchange rates, Tobin proposed a tax on all foreign exchange transactions. Such a tax (later named as Tobin Tax) would be at a rate which was a small faction of one percentage of the amount transacted, reflecting the difference between the exchange rates and thus countering any tendency to buy and sell the currency just with the intent to make profits arising out the differences between the exchange rate on different dates.

To illustrate, let us say the exchange rate between US$ and INR is 1:40.25 on a given date and a trader expects this rate to rise the next week to 1:40.30. Therefore on each dollar bought today and sold the next week he expects a profit of INR 0.05, which would be significant if the US$ sought to be bought is in considerably large proportions. Now if there is a situation in place wherein for every US$ purchased, there would be a tax equivalent to 0.1% of a base which would be the existing price of INR on the date dollar is purchased, then the trader would be required to pay INR 40.25 for every US$ purchased and INR 0.04025 as tax. On sale of US$ the next week, he would only receive INR 40.19925 (40.30 - 0.10075) as again a tax would be imposed on the exchange of the securities. Thus, even if the exchange rate does change as the trader expects, there would be a net loss to the trader in the entire series of transactions owing to the tax imposed.

In this illustration, though undoubtedly the amount of tax which is imposed is minuscule and also is not expected to contribute much to the government coffers, it does do away with the intention to buy the US$ only with the intention of selling it later on and earn from the differential amounts arising from the difference in exchange rates. Thus it would seem that the tax is successful in warding off those looking sheerly for arbitrage in exchange rate and thus the system (especially the central bank of the country) is rendered free to work upon other key issues rather than just to worry about short-term exchange rate fluctuations arising from such tendencies to take advantage of the differences in rates by warding them off with such tax.

The historical sequencing of the Tobin Tax is, however, more interesting. This is for the fact that Tobin Tax was originally proposed to deal with the consequential fallouts that would arise because of the declaration by Richard Nixon, the then President of the United States in 1971, to put an end to the era of dollar-gold convertibility. Tobin Tax was proposed in order to render the markets immune from a pure speculation driven pulls and pushes to the freely fluctuating exchange rates. However the idea did not catch any prominence then and simply gathered dirt for more than two decades until the debate to tax foreign exchange transactions in 1997 and this tax was seen as an propaganda of the anti-globalization movement.

The policy makers at the European Communities level seemed to have caught up with the idea and there was considerable discussion during the early 21st century at the EC level on this issue. In 2004 the European Central Bank even came out with its official stand on the issue. However the euphoria died down when proposal was rejected by the European Commission. Nonetheless the idea has led to considerable scholarly and research based writing and has been mooted quiet frequently across various quarters of the world.

For further readings, I would recommend;

1. Paul Bernd Spahn, The Tobin Tax and Exchange Rate Stability.
2. Opinion on the European Central Bank on Tobin Tax.
3. A host of links on Tobin Tax
4. Global Policy Forum on Currency Transaction Tax

2010 supplement:

Recently the European leaders called upon the IMF to impose a 'global Tobin tax' on banks to repay the loans that the markets had borne during the recessionary times for these banks most of which were almost on the verge of bankruptcy. A tight call but requires political will to implement such a system. Read more at these links (i) and (ii)