What’s All This Talk About a Tobin Tax

What is a Tobin Tax?

No, a “Tobin Tax” is not a new fee for those with the Tobin surname; rather, it is a proposed tax on all transactions involving the movement of currencies across borders, and is named after the man who devised it – James Tobin. Even though many are hearing this for the first time, Tobin initially suggested the tax way back in the early 1970s when US President Richard Nixon brought about the end of the Bretton Woods system by taking the US off the gold standard. ¹

The collapse of Bretton Woods in 1971 allowed currencies to “float” for the first time in nearly thirty years, and Tobin recognized that exchange rate fluctuations would give rise to exchange rate speculation. Tobin suggested the idea of implementing a tax on each foreign currency transaction to add to the cost of the trade, thereby penalizing short-term speculation. Here are Tobin’s own words on the goal of his tax as he explained in an interview with the German news magazine Der Spiegel in 2001 – many years after he first proposed the idea:

The idea is very simple: at each exchange of a currency into another a small tax would be levied – let’s say, 0.1% of the volume of the transaction. This dissuades speculators as many investors invest their money in foreign exchange on a very short-term basis. If this money is suddenly withdrawn, countries have to drastically increase interest rates for their currency to still be attractive. But high interest is often disastrous for a national economy, as the nineties’ crises in Mexico, South East Asia and Russia have proven. My tax would return some margin of maneuver to issuing banks in small countries and would be a measure of opposition to the dictate of the financial markets.

Despite occasional renewed interest in the concept of a currency exchange tax, no formal implementation ever took place. This was due largely no doubt, to the challenge presented in enforcing and managing the initiative as it would likely require an international institution such as the United Nations to effectively administer the tax.

So Why is the Tobin Tax Back in the News?

The main reason the tax is back in the headlines is simple – the recent banking crisis forced many governments to inject billions of dollars into the banking system to keep individual firms afloat. Advocates for the tax suggest that the money generated though the tax could be used to payback taxpayers and make the financial system more responsible for its actions. I would suggest that the idea of “punishing” the financial system plays more than just a passing role in the recent push towards an international currency tax.

Another, more recent phenomenon is the rise of – for lack of a better term – special interest groups that see a tax on the financial system as a convenient means to fund a wide range of projects. This seemingly includes everything from funding climate change initiatives, to providing additional money for developing nations. Interestingly, neither of these fits Tobin’s original vision for the tax as he noted with remarkable candor in the Der Spiegel interview:

I have absolutely nothing in common with those anti-globalization rebels. Of course I am pleased (with the renewed interest in his idea); but the loudest applause is coming from the wrong side. Look, I am an economist and, like most economists, I support free trade. Furthermore, I am in favor of the International Monetary Fund, the World Bank, the World Trade Organization. They’ve hijacked my name … The tax on foreign exchange transactions was devised to cushion exchange rate fluctuations.

What Will a Tobin Tax Cost Me?

The actual cost should international authorities decide to impose some form of Tobin’s transactional tax, is still unknown. Tobin originally suggested a rate of 1 percent but later modified it to a range of 0.1 to 0.25 percent of the trade’s total volume (10 to 25 cents per hundred dollars). At this point, this is the range that is most commonly reported, but there is no official word yet as to what the actual cost might be should the tax become a reality.

So why is the forex market singled out in this manner? James Tobin talks about “cushioning” exchange rate fluctuations to help stabilize individual economies, but I believe the discussion today has far more to do with opportunity. With current daily totals exceeding $3 trillion a day, and with most G7 countries in a deficit situation, the temptation to scalp a few pips off each transaction for themselves is just too great for many governments to ignore.

I mean after all, would a 0.25 percent tax on each forex transaction have prevented the current economic crisis? Of course not – governments already had the means to thwart the actions that led to the credit crunch through existing regulatory bodies – they just failed to do so. So let’s be honest and call this for what it is – a means to raise money disguised as a move to protect markets.

What Does This Mean for Me as a Forex Trader?

Assuming that some form of a transaction-based tax goes through – and I have to say, I believe it will as the support right now is unprecedented – the cost to trade forex will inevitably increase. A new tax could also lead to a decline in overall trading levels but with the depth of liquidity in the currency markets, I don’t see this as a major concern.

¹ Bretton Woods was the name of the small town in New Hampshire that hosted an international summit shortly after the Second World War. The goal of the meeting was to help Europe recover from the devastation of the war and established two major economic policies:

1. Most European currencies were “pegged” to the US dollar to help maintain their value
2. The US dollar as itself tied to the price of gold which at the time, was $35 an ounce

This meant that as the value of gold increased, so too did the value of the US dollar and other than buying and selling gold directly on the market, there was little the Federal Reserve could do to influence the dollar.

In the late 1960s and early 70s, the price of gold rose very quickly pulling the dollar along with it and according to the government, was responsible for the increase in inflation in the American economy. For this reason, President Nixon eliminated the gold standard requirement, thus allowing the dollar to fluctuate based on market conditions.

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