What is Tobin Tax and How Does it Work? What are its Advantages and Drawbacks?
When the fixed exchange rates under the Bretton Woods system were replaced with floating exchange rates in 1971, there was a massive movement of funds between countries that threatened to destabilise the global economy.
To counter this volatility and prevent the collapse of the global economy, the Tobin tax was proposed by Nobel Laureate and economist James Tobin to implement a penalty on short-term currency trading to stabilise global markets and discourage short speculation.
Read further to know how the Tobin tax was introduced and why it is important.
What is Tobin Tax?
A Tobin tax is a tax levied on international short-term capital flows. It is named after economist James Tobin, who derived this term in 1972 as a currency transaction tax. It is also levied on spot currency conversion or trades to discourage short-term speculation and penalise short-term currency trading.
The Securities Transaction Tax (STT) is a type of Tobin tax already in effect in India. It was introduced in 2004 by former Union finance minister P Chidambaram and is charged on all transactions involving securities listed on stock exchanges and mutual funds.
The proposed Tobin tax could be applied to international portfolio investors who sell their Indian bond investments before a particular time period. As a result, the investments last for a longer and more predictable length of time insulating the economy from extreme volatility and generating more money for the government.
The Tobin tax that was proposed was implied specifically on international portfolio investors who sell their bond investments bought in India before a set period of time. As a direct result, the investments last for a lengthier and more predictable period safeguarding the economy against extreme market volatility.
Background of Tobin Tax
In 1971, there was a surge in the flow of funds between countries, destabilising the global economy. Tobin tax was first used to prevent short-term currency speculation in the global financial system after the collapse of the Bretton Woods system. Speculation of short-term currency increased because of the free currency market, increasing the economic costs of transferring currency. This was the reason the Tobin tax was introduced. Numerous European nations used it to deter short-term speculation in the currency markets and stabilise currency rate exchange.
The Tobin tax’s initial notion was to penalise short-term financial operations into another currency. The Tobin tax, rather than being paid by consumers, would be paid by market participants to control the stability of a country’s currency. The Tobin tax was designed to create a method of managing exchange rate volatility. It has come to denote taxes on all kinds of financial transactions, with each country re-interpreting the concept in its own unique way according to its economic fluctuation and financial condition.
Also Read: What is Deferred Tax? How is it Calculated?
How Does Tobin Tax Work?
Generally, short-term currency transactions are subject to the Tobin tax. This tax is expected to regulate money flow in financial markets in favour of high short-term interest rates. Many other similar tax rules have been imposed in different countries to curb short-term financial movements during global crises. Managing financial transactions becomes difficult in the short-term market or trades because of rapid inflow and outflow. To curb this situation and discourage volatility and control speculative capital flows of money.
Tobin tax is inversely related to transaction period or length, which means that it decreases with an increase in the transaction period and vice versa. If the holding term is short, the tax burden is higher; if the holding period is longer, the tax burden is lower.
Examples of Tobin Tax
Here are a few examples of Tobin tax:
- Sweden introduced the Tobin tax in 1984. They levied a 0.5% tax on purchase and selling of stocks, but the results were not as anticipated. Sweden was able to only raise 50 million Swedish Kronors in contrast to the expected 1.5 billion Swedish Kronors. They also saw a decrease in bond trading volume by 85% in the first week after the implementation of the tax.
- Italy also incorporated high-frequency share trading, including a 0.02% tax on deals in 2013.
- Belgium, Estonia, Slovakia, Spain, Italy, Austria, Germany, Greece, France, Portugal, and Slovenia also opted to levy a 0.1% tax on the exchange of shares and bonds and a 0.01% tax on derivative transactions.
- The Tobin tax has also been implemented in Thailand, Chile, Brazil, and Malaysia. The tax is reported to have had the desired effect of reducing the highly volatile short-term currency flows in Brazil, Malaysia, and Chile to a lesser extent.
- The Securities Transaction Tax is a variation of the Tobin tax in India. The STT was implemented in 2004 and is charged on all transactions involving securities listed on stock exchanges and mutual funds occurring in the market.
Implementation of Tobin Tax
Tobin tax is only imposed on excessive money flow between financial markets. Banks and financial institutions pay the tax that profits from the market’s volatility. This happens due to many short-term speculative positions in the currency markets.
Although Tobin initially proposed imposing a tax of 0.5%, many economists opined on increasing the tax bracket from 0.1% to 1%. The idea was to be able to raise billions in revenue even at a minimal tax rate and use the proceeds for social and economic upliftment.
What are the Advantages & Disadvantages of Tobin Tax
Benefits of Tobin tax
There are several benefits of Tobin tax:
- The Tobin tax gives the government and central banks time to make the necessary changes to counteract the destabilising impacts of both outflows and inflows of currency.
- Paying taxes is a time-consuming process that slows the process of capital entrance and outflow.
- Tobin tax can be used for social development, especially for developing countries.
- The Tobin tax inhibits short-term speculation.
Limitations of Tobin tax
Although Tobin tax has many benefits, it has several limitations too:
- Tobin taxation may reduce the number of financial transactions, resulting in fewer job prospects or opportunities.
- Tobin tax has the potential to reduce asset liquidity.
- Reduced returns on various funds, such as pension funds, because banks would simply pass on the cost of taxes to customers.
- The possibility of lower market liquidity and increased price volatility may result in rising capital costs and investments may fall.
Also Read: What is Withholding Tax? What are its Rates? How is it Different from TDS?
Final Word
Tobin tax is imposed on several financial sector participants in order to implement a penalty on short-term currency trading, stabilise markets, and discourage speculative risks. It reduces the risk imposed on economies, particularly due to the frequent entry and exit of capital from markets. However, it can reduce the market’s liquid assets and prevent investors from engaging in the market.
FAQs
Ans. The alternative phrase for these broader tax schemes is the Robin Hood tax, because tax receipts from presumably affluent speculators finance general revenue, with the major beneficiaries being the less wealthy.
Ans. Tobin tax is a proposed charge on spot currency exchanges to implement a penalty on short-term currency trading and disincentivise speculation. It can be used to generate revenue in countries with a lot of short-term currency volatility.
Ans. Speculative trading, also known as speculation, is the act of buying or selling stock solely on the basis of hearing or believing that its value will rise. If your prediction is correct, you can make a profit; if not, you may not be able to make any profit. The outcomes can be both rewarding and risky.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
