Foreign exchange transactions need review<\/p>\n
Arya B. Gaduh, Centre for Strategic and International Studies (CSIS),
\nJakarta<\/p>\n
abgaduh@csis.or.id<\/p>\n
After the financial crisis, we all, reasonably, worry about
\nexchange rate volatility and fiscal sustainability. Yet this is
\nnot reason enough to justify haste and adopt the recently
\nproposed foreign exchange transactions (FET) tax. Contrary to
\nexpectations, such a policy will have no effect on volatility,
\nonly a small positive (but unsustainable) effect on government
\nincome. It will instead create a distortion that may impair
\ndomestic growth in the real sector and disadvantage smaller
\nenterprises.<\/p>\n
It was Nobel Laureate James Tobin who first introduced the FET
\ntax in 1972 (hence the term \"Tobin tax\"). He observed that the
\ncurrency market was often \"excessively\" volatile and his proposed
\nremedy was to introduce a small, uniform, international tax on
\nall spot transactions in the currency market. The aim was to
\nincrease the transaction costs for currency speculators, hence
\nreducing the exchange rate volatility. The final objective was to
\npromote a smoother international trading regime by reducing
\nmarket volatility.<\/p>\n
The side effect of the Tobin tax was, obviously, the sizable
\nrevenue of a small tax, given such a large tax base -- in 2001,
\nthe global average currency transaction was estimated at US$1.2
\ntrillion daily. This potential revenue gain, appeals to
\ngovernments in need, who think that a unilaterally introduced
\nTobin tax allows them to have their cake and eat it too: That is,
\nit will reduce volatility while increasing their coffers. These
\ngovernments are clearly mistaken.<\/p>\n
First, the tax envisioned by Tobin was not meant to be a
\nunilateral effort -- it required international coordination.
\nOtherwise, in a world of interconnected economies, it would be
\nvery easy to find a way around this tax. If the tax was applied
\nto the domestic market, traders could move their business
\nelsewhere. If it was applied to currencies, traders need only
\nshift to a vehicle currency that was not taxed. Hence, the
\nobjective -- of reducing volatility by increasing the cost for
\ncurrency speculators -- is not achieved by a unilateral tax.<\/p>\n
Second, even if international coordination is possible, the
\ntheoretically appealing Tobin tax is difficult to apply in
\npractice. For the tax to reduce volatility, it should be aimed at
\nspeculators, but not at market makers and financial
\nintermediaries, whose transactions provide market liquidity and
\nare a stabilizing factor.<\/p>\n
Yet, given the substitutability and complexity of financial
\ninstruments, differentiating between the two is not an easy task.
\nTo avoid taxes on spot transactions, for instance, speculators
\nmight trade in derivatives instead. Without a sophisticated
\nmonetary authority -- which clearly Indonesia doesn't have -- the
\ntax will be ineffectual in fending off speculators.<\/p>\n
These are enough reasons to question the volatility-reducing
\neffect of an FET tax. But what about the revenue-generating
\neffect?<\/p>\n
Depending on the proposed taxation scheme, the tax may or may
\nnot result in a significant revenue increase for the government.
\nWe have seen how easy it is for currency traders to divert their
\ntransactions elsewhere if the tax is applied to the domestic
\nmarket only. The time gap between the announcement of the tax and
\nits implementation will give traders enough time to move their
\ntransactions away from the Indonesian market, even as they keep
\nspeculating on the rupiah. The result: the revenue gains, if any,
\nmight not be as large as expected.<\/p>\n
On the other hand, the cost to the real sector can be
\nsignificant, both to trade and investment. A uniform foreign
\nexchange tax on the domestic market will unambiguously increase
\ntransaction costs, creating a distortion that will reduce trade
\nand will potentially reduce investment by increasing the cost of
\ncapital. As trade and investment are important sources of growth,
\nin the medium and long run, instead of increasing total revenue,
\nan FET tax can reduce it, due to the opportunity losses from
\nslower growth.<\/p>\n
Moreover, this cost will disproportionately be borne by
\nsmaller local importers, exporters, and travelers: Large
\ncorporations can hire sophisticated international fund managers
\nto avoid it. Such a policy clearly goes against the spirit of
\npromoting small and medium enterprises.<\/p>\n
So here you have it: A policy that won't reduce exchange rate
\nvolatility, has ambiguous total revenue effects, will impair
\ngrowth and unfairly disadvantages smaller enterprises. Yet it
\nappears to have \"universal support\" from various quarters. The
\nquestion is, why?<\/p>\n
The crisis has a lot to do with it. Traumatized by the tragic
\ndownfall of the rupiah, the public (economists included)
\ndeveloped resentment toward currency traders. While this
\nsentiment is understandable, the presently excessive fear over
\nexchange rate volatility isn't.<\/p>\n
Lest we forget, it was our relatively fixed exchange rate
\nsystem that provided speculators with the opportunity to attack
\nthe rupiah. With our present floating exchange rate regime, this
\nopportunity is gone. Unless we plan to abandon our current
\nexchange rate regime, we need to look elsewhere to justify an FET
\ntax.<\/p>",
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