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.