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What economics can tell us about the Tobin tax

© Paul Ormerod , September 2001. Reproduced with permission.

1. Background to the tax

The idea of the Tobin tax is superficially very appealing. Dealers on Wall Street and in the City of London move huge amounts of currency around the world, causing fluctuations in exchange rates between currencies. The Euro, for example, has been weak for almost the whole of its existence. But the leading politicians and bankers at its launch in January 1999 proclaimed that it would be strong, that it would replace the dollar as the world's leading currency. How tempting it is not to blame themselves, but to place the blame on currency speculators.

It was even more tempting to point the accusing finger at currency dealers in 1997/98, when speculation against East Asian currencies sparked of a chain of events which led to sharp recessions in many of those countries. More recently still, several South American countries such as Argentina have been experiencing similar events.

Currency speculators are disliked by many, not just by governments who see their plans disrupted. Indeed, outside their immediate family circles it is hard to find anyone with a good word to say about the speculators. Surely, if their activities could be somehow curbed, the world would be a more ordered place and fluctuations on currency markets would be much less extreme?

We can use economics to get a better understanding of what might happen if a Tobin tax were introduced. There is of course no guarantee that the answers we get will be correct, and the only sure way of finding out is actually to introduce the tax. But economics certainly helps us think more clearly about what might happen. In doing this, we have to set aside our own personal opinions about financial markets and the people who deal in them. Economics is not about describing the world as we would ideally like it to be. It is about understanding how the world actually works. We must examine the evidence carefully, and form an opinion as scientists. We may then be able to go on suggest ways in which the world could be improved. But in order to do this, we must first of all understand how it operates.

2. The Tobin tax: its aims, and whether it would succeed in meeting them

The idea of the Tobin tax is to tax transactions on foreign exchange markets. All deals which exchange currencies would be subject to a tax. Currency dealings related to genuine trade flows rather than speculation could be exempt, but these are only a small fraction of the total trades in currencies which are carried out daily. The purpose of the tax is to achieve two aims:

  • to reduce the amount of dealing in world currency markets

and by so doing, to meet the principal aim of the tax which is:

  • to reduce the size of fluctuations of currencies against each other

2.1 Reducing the amount of dealing in world currency markets

2.1.1 The theory

There are good reasons to believe that this would actually happen. Simple economic theory says that if the price of something is increased, the demand for it will usually fall. The Tobin tax can be thought of as a tax - an increase in price - on deals on the currency markets. So the tax would reduce the 'demand' for dealing. In other words, the number of deals would be reduced.

2.1.2 The empirical evidence

We have not just theoretical evidence, but reliable empirical evidence on the likely impact of the tax. There are some financial markets where taxes on dealing already exist. The UK stockmarket is one of these, where deals in shares are subject to 'stamp duty'. A tax of one half of one per cent is levied on deals, and the revenue goes to the Chancellor of the Exchequer. Few other countries levy such a tax nowadays, and the rate in the UK has varied over time.

By careful analysis of what happens when the tax rates on dealing in shares has been changed, both in the UK and elsewhere, economists have estimated the impact of the dealing tax on the number of deals carried out. These studies use advanced statistical techniques to analyse the evidence. A recent estimate is that the abolition of the tax in the UK would lead to a dramatic increase in the number of transactions in shares, perhaps almost doubling in volume. By the same token, an increase in the tax would cut back sharply the number of deals.

So far, so good. The evidence suggests that the Tobin tax would indeed reduce substantially the number of deals in currencies.

2.2 Reducing the fluctuations in world currency markets

2.2.1 The empirical evidence

But would it reduce the volatility of currency movements? The same studies which say that the tax would reduce the number of transactions, do not say that the fluctuations in prices would be reduced. Indeed, they can find no evidence that this would happen at all.

We need not look to rather difficult statistical studies carried out by economists to form an opinion. We can look at the straightforward evidence of what has actually happened to the UK stockmarket over the past few years. It has hardly been quiet and orderly. Prices have fluctuated markedly, despite the existence of a Tobin-like tax on dealings in shares. Figure 1 below shows the monthly percentage changes in the Financial Times Share Index over the period January 1990 to July 2001.

Shares move up and down, often by more than 5 per cent in the course of a single month. In fact, in no fewer than 62 months the index rose by more than 5 per cent, and fell by more than 5 per cent in 42 months. And remember that this has happened in a financial market in which there is a tax on dealing in shares.

Click to download the image
Figure 1: Monthly Percentage Change in Financial Times Share Index, January 1990 - May 2001

2.2.2 The theory

We can go on from the empirical evidence, and use some very modern economic theory to understand why a tax is unlikely to reduce the fluctuations in currencies. Indeed, the more successful it is in cutting back the number of deals, the more it runs the risk of actually increasing volatility.

Setting up a theoretical model is like drawing a map of an area. Any map gives a simplified picture of reality. The trick to making a good map is to make it sufficiently straightforward for it to be able to be used, and yet at the same time to capture the key features of an area. This way, we can find our way around and learn about an area. Economics contains lots of theoretical models, all of which are trying to illuminate a particular issue.

The mathematics involved in this particular theoretical model are hard (Note). But the basic reasoning can be put into words. The key idea that dealers in foreign exchange markets do not just from opinions by themselves, but are influenced by the behaviour of others. The more people think that a particular currency is weak and hence want to sell it, the harder it becomes for anyone to take a different view and swim against the tide.

There are some famous examples of this principle, of financial schemes which draw in more and more people in spectacular fashion, until the whole edifice collapses. Historical classics of this kind include the Dutch tulip mania of the seventeenth century, when the price of tulip bulbs was bid up to astronomical levels, and the notorious South Sea bubble in Britain in the early eighteenth century. The only rationale for these events is that people became influenced very powerfully by the behaviour of others. As prices rose ever more steeply, simple economic theory suggests that fewer and fewer people would want to buy. Instead, in these speculative markets, more and more people became desperate to buy. No doubt the mania of the late 1990s will be cited by future historians as yet another example of this collective mania.

A more mundane illustration of the principle was given by Keynes. In the politically incorrect Britain of the 1930s, beauty competitions were frequently held in the popular press. But the task was not to choose the most beautiful entrant, but to guess which of the entrants most people who cast a vote would choose. Keynes likened behaviour in the financial markets to this same principle. A currency might be strong in terms of the fundamentals of its economy, but a dealer who thought that most other dealers thought it was weak, would sell it rather than buy it.

Theoretical models of this kind built to describe financial markets show the sorts of high volatility which real data exhibit - like the data plotted in Figure 1 above. They give a realistic description, using some simplified rules of behaviour, of a key feature of financial markets, namely their high volatility. In short, they give us a good map.

Now, one of the advantages of a good theoretical model is that we can use it to think about what might happen if circumstances were different. At present, there is an enormous number of deals in currencies carried out every day. We have good evidence that the Tobin tax would reduce this number. And we can use our model to ask: what is likely to happen to the volatility of currencies if the number of deals is cut back?

The answer from the model is unequivocal. The volatility will certainly not be reduced. Indeed, if the number of deals fell really drastically, volatility would rise, not fall.

3. Conclusion

So economics suggests that a Tobin tax would succeed in its aim of reducing the amount of dealing on world currency markets. But it would not meet its main aim of reducing the fluctuations which exist on the world financial market, despite the fact that less trading would take place. Both empirical studies and theoretical models point to the same conclusions.

We might still want to introduce such a tax in order to raise revenue, but that is a matter of political choice. Economics tells us that if our intention is purely to reduce the volatility of financial markets, the tax is unlikely to meet our aim.


Paul Ormerod is the author of the Death of Economics (1994) and Butterfly Economics (1998), both published in the UK by Faber and Faber.




The first version of this type of model was published in the Bank of England Quarterly Bulletin in 1995 by Alan Kirman