What is wrong with corrective taxation?

The head of the British Financial Supervision Authority, Lord Turner, has set off a storm after his remarks on the front page of Financial Times on Thursday 27 August. After having spent endless hours trying to clean up the mess left in the City of London and elsewhere in the British financial system, he has apparently become impatient with the lack of initiatives seeking to prevent or soften financial meltdowns in the future. The current mood of relief and return to “business as usual” seems to have made Lord Turner speak his mind. The pages of Financial Times have subsequently been swamped by opinions denouncing the proposal, and the newspaper has joined the choir in an editorial. 

 

Lord Turner suggested that financial firms should pay a transaction tax with the alleged main purpose to reduce the size of the City of London and, more generally, of the financial sector in the UK. As I read the comments by Lord Turner, he envisaged a relatively small tax on all transactions of financial institutions operating in the UK. Evidently – and preferably – such a tax could also be imposed by other countries. Regrettably the misleading label “Tobin tax” was affixed to Lord Turner’s suggestion. A Tobin tax is a small tax on all currency exchange transactions with the purpose of throwing sand in the wheals of international currency markets. The Tobin tax was discussed a lot after the Asian crisis, but has never been implemented anywhere. Lord Turner’s suggestion related to all financial transactions so it is clearly not a Tobin tax.

 

I am in no doubt that Lord Turner’s proposal exhibits many unsettled issues and (as other taxes) may affect the competitiveness of the financial sector in countries adopting the tax. The principle, however, seems to fundamentally sound. I am teaching both international finance and public economics, and for me it is a bit surprising that Lord Turner’s remarks have become so controversial. In public economics “corrective taxation” is usually the first remedy suggested when an economic activity inflicts a negative external effect. Taxes on cars, energy and tobacco are usually rationalised by the negative effects on others of driving, CO2 emission and smoking. The corrective or Pigouvian taxes are then seen as means to reach a socially acceptable level of automobile driving, energy use and smoking.

 

Lord Turner’s proposal rests on the assumption that modern finance has negative external effects that are not otherwise internalised. I guess these external effects take two main forms: 1) Individuals and firms are affected by excessive fluctuations in financial markets resulting in sudden disruptions of market access (e.g. to credit). 2) The main financial firms have to be bailed out and the bills are eventually shouldered by the taxpayers. In this context, it does not seem unreasonable to impose a corrective tax on the activities associated with the negative external effects. The tax should be designed so as to address the negative externality problem and, thus, move the economy closer to it social optimum.

 

A financial transaction tax would also seem reasonable from a distributional viewpoint; the revenue generated could be accumulated and spent whenever a government bailout is needed. In this context a tax may be superior to the main alternative, namely reserve requirements on specific transactions (as applied hitherto). From the viewpoint of the financial firms affected, higher reserve requirements in many ways function like a tax, but the problem is that the monetary gains from higher reserve requirements are dispersed and, thus, not easy to appropriate and accumulate by the authorities.

 

As a teacher of public economics, I find it a bit unfortunate that Lord Turner’s idea of a financial transaction tax has been shot down by most commentators at such an early stage. The proposal lacks specificity and may exhibit fundamental problems. Still, why not take it seriously and try to work out whether it could be implemented and whether it has the ability to dampen excessive volatility in financial markets?