Is a Tobin tax feasible?
The Tobin tax - a tax on financial transactions - is very much in the news. Before one gets to the issue of the desirability of such a tax, one has to address the question of whether the policy is even feasible. I am skeptical. Financial transactions are easy to move: If two parties to a financial contract can just as easily sign and enforce the contract in the Cayman Islands as in New York or London, there is little point in US or UK policymakers imposing a Tobin tax. Unless, of course, moving the finance industry offshore is the policy goal.
In his column, Paul Krugman raises and then dismisses this issue as follows:
On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair. Take, for example, Tobin’s original proposal to tax foreign exchange trades. How can you do this, when currency traders are located all over the world? The answer is, while traders are all over the place, a majority of their transactions are settled — i.e., payment is made — at a single London-based institution. This centralization keeps the cost of transactions low, which is what makes the huge volume of wheeling and dealing possible. It also, however, makes these transactions relatively easy to identify and tax.
This passage left me scratching my head. Even if most transactions are now settled in one place, that need not be the case in the future after a significant change in the policy environment. It is not as if London has some large, natural comparative advantage in financial settlement that would persist despite a tax on transactions there. The finance industry is set up to take advantage of very small price differences. If London became ever so slightly more expensive, wouldn't contracting and settlement quickly migrate elsewhere?
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2 comments
It is not as if London has some large, natural comparative advantage in financial settlement that would persist despite a tax on transactions there.
Well not in the medium-long term, no. But clearing does provide HUGE cost savings. See http://www.cls-group.com/Products/Settlement/Pages/ForFX.aspx:
CLS significantly improves liquidity management by providing Settlement Members with a multilateral net position on which to base required daily funding rather than gross transaction-by-transaction funding. This reduces necessary funding by over 95% each day. This means that for every US$ 1 trillion of value settled, the CLS community has to fund less than US$ 50 billion in cash. Payment risk is also reduced by the limited number of pay-ins and pay-outs between Settlement Members and CLS each day.
Participants can earn significant cost savings from multilaterally netted funding, and rationalising and consolidating nostro relationships. On average, only 26 payments are made each day per 10,000 instructions settled, a 99.75% payment volume reduction.
CLS results in further cost savings for participants by greatly reducing the number of interest compensation claims from failed settlements.
And the risk reductions are equally huge.
Setting up a FX clearing house takes many years, not months. Persuading the mass of banks to switch to a new CH, losing the much of the netting risk in the meanwhile will be tricky. And the new location would have to be one with a rock solid legal and regulatory system.
If London became ever so slightly more expensive, wouldn't contracting and settlement quickly migrate elsewhere?
Quickly? No. Contracting may, but settlement certainly won't.
db
Very interesting article. I am fearful that the financial industry is just as nimble as you suggest.
It's not a Tobin tax but I guess this is being put to the test right now on a micro-scale with Alistair Darling's latest friendly announcement about the bonus tax.
It only applies from now to April 2010 but how many banks will flee the UK, I wonder, now that they see the writing on the wall? What awaits them in April 2010 and will they stick around to find out?