Foreign exchange transactions need review

Foreign exchange transactions need review

Arya B. Gaduh, Centre for Strategic and International Studies (CSIS),
Jakarta

abgaduh@csis.or.id

After the financial crisis, we all, reasonably, worry about
exchange rate volatility and fiscal sustainability. Yet this is
not reason enough to justify haste and adopt the recently
proposed foreign exchange transactions (FET) tax. Contrary to
expectations, such a policy will have no effect on volatility,
only a small positive (but unsustainable) effect on government
income. It will instead create a distortion that may impair
domestic growth in the real sector and disadvantage smaller
enterprises.

It was Nobel Laureate James Tobin who first introduced the FET
tax in 1972 (hence the term "Tobin tax"). He observed that the
currency market was often "excessively" volatile and his proposed
remedy was to introduce a small, uniform, international tax on
all spot transactions in the currency market. The aim was to
increase the transaction costs for currency speculators, hence
reducing the exchange rate volatility. The final objective was to
promote a smoother international trading regime by reducing
market volatility.

The side effect of the Tobin tax was, obviously, the sizable
revenue of a small tax, given such a large tax base -- in 2001,
the global average currency transaction was estimated at US$1.2
trillion daily. This potential revenue gain, appeals to
governments in need, who think that a unilaterally introduced
Tobin tax allows them to have their cake and eat it too: That is,
it will reduce volatility while increasing their coffers. These
governments are clearly mistaken.

First, the tax envisioned by Tobin was not meant to be a
unilateral effort -- it required international coordination.
Otherwise, in a world of interconnected economies, it would be
very easy to find a way around this tax. If the tax was applied
to the domestic market, traders could move their business
elsewhere. If it was applied to currencies, traders need only
shift to a vehicle currency that was not taxed. Hence, the
objective -- of reducing volatility by increasing the cost for
currency speculators -- is not achieved by a unilateral tax.

Second, even if international coordination is possible, the
theoretically appealing Tobin tax is difficult to apply in
practice. For the tax to reduce volatility, it should be aimed at
speculators, but not at market makers and financial
intermediaries, whose transactions provide market liquidity and
are a stabilizing factor.

Yet, given the substitutability and complexity of financial
instruments, differentiating between the two is not an easy task.
To avoid taxes on spot transactions, for instance, speculators
might trade in derivatives instead. Without a sophisticated
monetary authority -- which clearly Indonesia doesn't have -- the
tax will be ineffectual in fending off speculators.

These are enough reasons to question the volatility-reducing
effect of an FET tax. But what about the revenue-generating
effect?

Depending on the proposed taxation scheme, the tax may or may
not result in a significant revenue increase for the government.
We have seen how easy it is for currency traders to divert their
transactions elsewhere if the tax is applied to the domestic
market only. The time gap between the announcement of the tax and
its implementation will give traders enough time to move their
transactions away from the Indonesian market, even as they keep
speculating on the rupiah. The result: the revenue gains, if any,
might not be as large as expected.

On the other hand, the cost to the real sector can be
significant, both to trade and investment. A uniform foreign
exchange tax on the domestic market will unambiguously increase
transaction costs, creating a distortion that will reduce trade
and will potentially reduce investment by increasing the cost of
capital. As trade and investment are important sources of growth,
in the medium and long run, instead of increasing total revenue,
an FET tax can reduce it, due to the opportunity losses from
slower growth.

Moreover, this cost will disproportionately be borne by
smaller local importers, exporters, and travelers: Large
corporations can hire sophisticated international fund managers
to avoid it. Such a policy clearly goes against the spirit of
promoting small and medium enterprises.

So here you have it: A policy that won't reduce exchange rate
volatility, has ambiguous total revenue effects, will impair
growth and unfairly disadvantages smaller enterprises. Yet it
appears to have "universal support" from various quarters. The
question is, why?

The crisis has a lot to do with it. Traumatized by the tragic
downfall of the rupiah, the public (economists included)
developed resentment toward currency traders. While this
sentiment is understandable, the presently excessive fear over
exchange rate volatility isn't.

Lest we forget, it was our relatively fixed exchange rate
system that provided speculators with the opportunity to attack
the rupiah. With our present floating exchange rate regime, this
opportunity is gone. Unless we plan to abandon our current
exchange rate regime, we need to look elsewhere to justify an FET
tax.