Paul Krugman, in a column last month for the New York Times, endorsed a tax on financial transactions, proposed recently by Adair Turner, Britain's top financial regulator. It is important to distinguish this Turner proposal from the original Tobin tax on international flows and these two taxes in turn from the kind of coordinated capital controls I proposed in this article last month and in this blog post two weeks ago.
Tobin's original idea was to discourage speculation by taxing flows of international capital. The Turner variant is to tax all financial transactions: domestic and international. What they have in common is that both are seen as structural measures to be applied regardless of the state of the macroeconomic cycle.
In contrast, the capital controls that are now being proposed are more in the spirit of "macroprudential" measures to be taken in response to surges in international capital flows (and not to steady and permanent flows) to emerging markets that have the potential of creating bubbles in asset prices, including exchange rates. Such measures are therefore intended to be taken during the upswing of the cycle and not at all times.
The case for a number of emerging-market countries coordinating such measures under the auspices of the G-20 is to avoid the stigma of being labeled market unfriendly, a stigma that is a consequence of the strong—but misguided—belief system that all foreign capital in all quantities is always good. This is important because the magnitude of the tax that emerging-market countries may need to impose could be substantial in magnitude and not-so-short term in duration. Effectively deterring inflows would require a tax that substantially narrows the return differentials driving flows in the first place. With near-zero interest rates in the United States, these differentials could be as high as 5 to 7 percent for a typical emerging-market country and could persist because the US Fed is likely to keep rates low for some time. Few countries would be willing, on their own, to risk imposing such "drastic" measures.
A second argument for coordination is that if only a few countries were to throw "sand in the wheels" (to use Tobin's famous phrase) of international finance, the flows could simply be diverted to other emerging-market destinations, aggravating the problem for them.
Clearly the magnitude and type of action should vary across countries, depending on their macroeconomic situation and the available alternative policy choices. For example, if capital inflows are creating a housing bubble, then one country may be able simply to take prudential measures such as higher provisioning requirements for real estate lending. But another may have to stop or moderate the flows in the first place.
But a third argument for coordination is that the magnitude of the tax imposed by one country will depend on actions taken by other emerging markets. For example, the more China persists with its exchange rate policy, the less willing other emerging-market countries will be to allow their currencies to appreciate, and therefore more willing to apply stronger brakes to capital flows. Coordination will also serve as an accountability mechanism for emerging market countries. To prevent indiscriminate controls, countries should be able to justify their actions to each other. For example, Korea may have less basis for applying taxes than, say, Brazil—whose currency has appreciated more significantly.
Fourth, an important risk with taxing inflows is that it could simply lead to evasion of the tax or restriction (through under or over invoicing of trade) or to transactions shifting offshore. Coordination, including the cooperation of industrial country jurisdictions to which these transactions could shift, could then become a way of minimizing this risk (it can never really be eliminated) of such circumvention of controls. The possibility of evasion or circumvention of restrictions on inflows cannot in itself be decisive in rejecting restrictions. We do not abandon levying income or other taxes just because they can be evaded; we just design and implement them in a manner that maximizes their impact while minimizing the risks of evasion.
Paul Krugman noted in his column that United States officials are dead set against the financial transactions tax. For the same reason, they are likely to oppose actions by emerging-market countries to impose and coordinate controls on foreign flows. Another test for the G-20 looms. If it and the old G-7 within it can respond to emerging market concerns, we can be hopeful. Otherwise, it will just be the G-7 (plus who?) all over again.
