A Tax to Rein in Finance C.P. Chandrasekhar

It is a proposal that refuses to die. When Finance Ministers of the overactive G20 met at St Andrews, Scotland in early November, the UK’s Prime Minister Gordon Brown decided to use what would be the last meeting under his presidency to make a case for taxing finance. His argument was simple. Over the last two years, fragility or failure in the banking system has necessitated using tax payers’ money to bail out banks. And the evidence seems to be that once the losses of banks resulting from the speculative fervour of managers in search of bonuses had been absorbed and their capital base refurbished, these managers or their replacements have gone back to playing the same game and earning similar bonuses, keeping the prospect of future failure alive. It is obviously unjust and even infeasible to repeatedly call upon the public at large to pay for the errors, forced or unforced, of the bankers. So post-crisis financial reform, Brown had argued, must include measures that require banks to pay for the (extremely high) likelihood that their actions would burden tax payers with the costs of rescuing banks in future. In words that caught the world’s attention he said: “It cannot be acceptable that the benefits of success in [banking] are reaped by the few but the costs of its failure are borne by all of us”. Impeccable logic, anyone would say.

There were four such measures to deal with the problem that Brown had tentatively advanced. One was an extension of the current remedy of forcing banks to provide for potential losses in advance. World governments should consider requiring banks whose failure was seen as being systemically damaging to hold more capital to cover potential losses than required of other less systemically relevant banks. However, if the crisis has taught us anything, it is that this idea of differential levels of “capital adequacy” would take us nowhere. If systemically risky banks are to provision for a higher level of losses, the question that would arise is how high is “higher”? This is because, as became clear from banks’ involvement with the shadow banking system through on- and off-balance sheet transactions, managers seeking to increase profits would siphon money into the less regulated and more profitable entities so as to earn revenues they cannot legitimately seek. The higher is the pre-emption of their resources for insurance purposes, the greater would be the desire to indulge in such activity. In the event, if and when the more risky banks fail the ripple effects would engulf the systemically risky institutions as well, and whatever level of capital adequacy is specified may prove inadequate. Therefore, as Nouriel Roubini, among others, still argues: “The true solution to the too-big-to-fail problem requires more radical choices. In addition to an insolvency regime, such institutions should be broken up and unsecured creditors of insolvent institutions should have their claim automatically converted into equity. A separation of commercial banking and risky investment banking should also be considered. Thus, some variant of the Glass-Steagall Act should be reintroduced.”

Two other variants of the insurance scheme were advanced by Gordon Brown and were also non-controversial, even if not likely to be immediately taken up. One was the creation of a pool of money financed by banks and/or their customers that could be used to finance orderly bail-outs as and when required. And the other was mandating contingent capital requirements or the holding of assets whose value or benefit is realised only when an event that is uncertain occurs. These are measures similar to deposit insurance, excepting that it is not just depositors who are insured but the banks themselves. The difficulty with these schemes is that there is no guarantee that they would provide adequately for the costs of a failure. The advantage they have is that they are likely to garner international support, since they limit, while leaving open, the burden that would be imposed on financial institutions today to meet costs that may have to be met tomorrow. From the point of view of finance there is ample scope to negotiate and render these costs small enough to bear for institutions that are too big to fail.

In the event, the really controversial of Brown’s proposals was his fourth option of imposing a tax on financial transactions that could either be used to create a contingency fund or be spent on socially beneficial projects so that taxpayers are compensated today for any costs they may be called upon to bear in future. The idea is not new and was, therefore, immediately labelled the “Tobin Tax”, even though it differs significantly from the tax on foreign currency transactions that was proposed by Nobel Prize winning economist James Tobin. After the collapse of the Bretton Woods agreement and the shift to floating exchange rates in the early 1970s, Tobin proposed a small levy on transactions in foreign exchange markets to discourage speculation and endow currency markets with a degree of stability. The proposal, which was questioned by some who felt that it attempted to throw grains of sand in the wheels of finance when what was required were boulders, was never taken up because it needed to be implemented by all countries simultaneously if it was to be successful. Belgium did subsequently pass a law to implement a Tobin-type tax, but made its implementation contingent on a similar law being adopted in all countries in the euro zone. But that was not to be, since such consensus was lacking.

However, the idea was revived after the Southeast Asian financial crisis of 1997, when it became clear that once restrictions were removed on cross-border flows of financial capital, speculative flows seeking to profit from differentials in the rates of return across countries and sectors could result in boom-bust cycles with severely damaging consequences for the real economy. The idea of the tax, while retaining the Tobin label, was extended to curb speculative capital flows by reducing their profitability and was promoted by stating that the revenues collected from such a tax could be used to further development in the world’s poorest countries. In the process, support for the Tobin tax was substantially enhanced and was seen as akin to opposition to policies and institutions (such as the World Bank and the IMF) that were for reduced controls on private capital movements across borders. In fact, Tobin distanced himself from the “anti-globalisation rebels” who he complained had hijacked his name for wrong ends.

However, the wider support for Tobin-tax Mark II notwithstanding, little progress was achieved. It was, not surprisingly, opposed by finance. It was also opposed by countries which felt that imposing such a tax, when others were not opting for it, would drive capital out of their countries and/or undermine their existing role or potential role as global financial centres. And once again the debate on the need for and feasibility of such a tax petered out.

However, since financial crises do not disappear but only recur, often with greater intensity, in contemporary capitalism, the idea was bound to survive. We are therefore witnessing now the revival of Tobin tax Mark III in the wake of the global financial and economic crisis of 2008. In August 2009, when an effort was still underway to redirect attention from stalling the recession to reforming finance, a person of no less significance than Adair Turner, chairman of Britain’s Financial Services Authority and author of the much discussed Turner Review of the implications of the financial crisis, argued in an interview published in Prospect magazine that the debate on bankers’ bonuses has become a “populist diversion” and that more drastic measures may be needed to cut the financial sector down to size. One such measure was a Tobin-type tax on financial profits. “If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit,” he said.

Coming from the chief of the financial watchdog in the country that is home to the City of London (the second most important global financial market after New York), this was a significant statement. It showed that at least some people responsible for the operations of the City were not going to protect finance at all cost in order to retain the competitiveness of the City as a global financial centre. In fact, Turner reportedly held that the FSA should “be very, very wary of seeing the competitiveness of London as a major aim”, since the City had become a destabilising influence in the British economy.

It was not surprising that Turner’s statements generated a backlash. According to the Financial Times (August 27, 2009): “A chief economist at a big bank described the suggestion internally as “a stupid idea”, while an executive at one European bank said: “Global taxes don’t happen. Unless next month’s G20 meeting can suddenly pull something out of the hat, this will be largely ignored.”

The London meeting did indeed ignore the proposal, even though there were hints of support from France and elsewhere. But come November and the Turner-Tobin proposal gained new momentum with Prime Minister Gordon Brown weighing in for it. He, however, made it clear that Britain would consider adopting the tax only if the initiative was global. And, as expected, not long after Brown’s speech US Treasury Secretary Tim Geithner made clear that the US was not willing to support a financial transaction tax. Canada, Russia and others, besides the IMF and the European Central Bank, have joined the group of dissenters, increasing the probability that the proposal will be shelved once again.

In the circumstance many argue that Brown’s declaration of support for a financial transactions tax move may just be his last effort to gain populist mileage from the presidency of the G20 and shore up his waning image at home. However, his actions have given a lease of life to an idea that just will not go away. Turner’s assessment that the logic that “more complete markets were good and more liquid markets are definitionally good” is no longer trusted, and that the crisis “requires a very major reconstruct of the global financial regulatory system, [not] a minor adjustment,” cannot be easily ignored. Hence the proposal for a Tobin-type financial transactions tax is likely to remain on the table.