Today, there is much frustration with the financial sector. Society’s precious savings are not being put to the best of uses — investing for the social good. It is unnecessary to repeat at length what has gone wrong over the last few years. The situation can be summed up as one where greed met incompetence, with near fatal economic results.
This has renewed interest in a financial transactions tax (FTT), sometimes known as a ‘Tobin tax’ (after the late James Tobin, who first argued for a tax on currency transactions to dampen destabilizing speculation). Many recent proposals for an FTT go beyond currency trading to encompass a far wider set of financial transactions. Some forms of FTT are technically feasible. Britain has had a stamp duty since 1694 (currently applied to transactions in shares and property). France seems likely to go ahead with a similar FTT. Some EU member states are pressing for a more comprehensive European-wide levy to tax financial transactions where at least one party is located in the European Union.
But I have two concerns: what is the principal aim of the tax? And, secondly, what will the generated revenue be used for? Others have raised concerns over whether ‘financial engineering’ can be used to avoid the tax. However it seems to me that this technical issue while important, and one that will affect the design of any tax, is less crucial than reaching clarity on the aims of an FTT and the use of the resulting revenue. If neither is clear then a more comprehensive FTT will not gather the support it probably deserves.
First, what is the aim of an FTT? If the main purpose of a tax is to collect revenue, then the activity to be taxed must be buoyant. Setting the tax rate too high chokes off the activity, and therefore the revenue. To maximize revenue from the financial sector, the FTT needs to be set low. But if instead the aim is to reduce the size of the financial sector, or some parts of it (undesirable forms of short-term trading, for example) then the tax rate needs to be high. If society decides that large financial sectors, or parts of them, do social harm then, like the taxation of cigarettes, an FTT needs to be set high to discourage the activity.
Does finance harm society? The recent financial crisis has taught us that banks can reach a size and complexity beyond which they can do real harm. As size and complexity rise, so managers lose their understanding of what risks they face. Capital is then misallocated in ways that are not best for society. Size and complexity also increase the pay of managers, giving them a perverse incentive to take risks that can lead to the destruction of their institution — that is unless it is bailed out with public money. This is likely when banks are so large that their collapse threatens to bring down the financial system, and the economy with it.
Banks continue to be ‘too big to fail’, especially in Europe. Bank distress results in public bailouts (diverting public money away from much better uses), as well as lost output and employment — the social costs seen since 2008. Issuing public debt to shore up banks narrows the fiscal space of governments limiting their ability to meet pressing social needs, including those of the world’s poorest countries and poorest people. The result is that finance remains the master of the real economy, not its servant.
An FTT does not tackle the core problem of the present financial system, namely banks that are too big to be allowed to fail. An FTT at a high rate may reduce the size of the financial system, but it is not evident that it scales back big banks. Indeed, a high-rate FTT could encourage banks to merge since bigger banks can absorb the cost of an FTT better than smaller banks, thus exacerbating the ‘big bank’ problem. At best, some of the revenue from an FTT can be used to bail out tomorrow’s bust banks — so providing us with a bigger financial fire engine, but not fewer fires.
Fundamentally, individual banks need to be reduced to a size where their failure does not impose excessive social costs. Tightening competition and regulation legislation to break up big banks and taxing, on a sliding scale, bank profits as well as managers’ salaries and bonuses, are ways to cut banks down to the right size (and possibly reduce the alarming rise in the inequality of wealth and income). The FTT does not tackle this core problem of the present financial system, which will almost certainly lead to another calamity in the near future.
Questions also arise as to the use of the revenue yielded by an FTT. Fundamentally, what is the revenue to be used for? Is it to:
(i) claw back the public money that saved private banks in the recent and ongoing bailouts?
(but the banks will pass at least part of the tax back to the public by raising their fees);
(ii) support the present ‘fashion’ for draconian fiscal austerity using the revenues from the FTT to repay foreign creditors? (a role for an FTT in Greece, perhaps?);
(iii) fill the long-term hole in the public finances of Europe and North America? (e.g. health costs and public pension bills);
(iv) finance investment in long-term growth? (investing in more social and economic infrastructure to provide jobs, for example); or
(v) scale up foreign aid and the financing of global public goods, such as environmental protection as well as climate change adaption and mitigation?
The last of these objectives, financing more aid and global public goods, dominates of course the discussion in development circles. These seem to be a good use for the FTT. But once treasuries get their hands on the revenues they will be tempted to pay down national debts. Politicians might be agreeable to some allocation of the FTT to more foreign aid and global public goods. But will the financing from the FTT be additional to existing finance for these purposes, or will it be offset, wholly or in part, by diverting some of the existing aid and environment budgets to other uses? Ultimately, the same preferences that determine whether a dollar of existing revenue is allocated to aid and global public goods will underpin the use of new revenue streams, including that from an FTT.
An FTT could be used to capitalize a public development bank — that can then make investments for society’s long-term gain, where those investments are not provided sufficiently by the market (social housing is one example, infrastructure is another). Public development banks in developed countries could, as part of their overall portfolio, lend in developing countries, thereby diversifying (and hence reducing) the bank’s risk. The European Investment Bank already does this, and more national development banks could help to reorientate the financial system towards social need.
If we believe that a financial system dominated by private banks fails to use our savings for the good of society — it misallocates capital — then an increase in public ownership within the financial system makes sense. An FTT in itself does not correct the misallocation problem. Rather, the FTT provides a revenue source that could help capitalize a public development bank. And to provide that revenue the FTT must be designed to avoid choking off private investment in the financial system.
Some forms of the FTT are feasible. But such a tax is not a panacea for the ills of global finance — the neglect of smaller and poorer countries, for example — nor of capitalism as an economic system. If an FTT is to be used effectively, and if it is to gain more political momentum, we need an answer to the question: what is the best use of the revenue? Only then can we start to make finance the servant of society and not its master.
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This article, which originally appeared in the WIDER Angle newsletter, is based on a presentation at the Helsinki Process +10 conference, organized by the Ministry for Foreign Affairs of Finland and held at Hanasaari 13-14 February 2012.