While there is little doubt a Tobin tax increases the cost of investing, foreign portfolio investors will look at the overall costs and returns in India compared to that in other parts of the world.
Ganesh Raj
Tax Partner, National Leader, Ernst & Young, India
‘A Tobin tax will lower market liquidity and hence raise volatility. In other words, it can prove more damaging than the exchange rate instability it is aimed at curing’
In the context of large capital flows, countries have used a wide range of instruments. One such instrument consists of explicit taxes or tax-like measures on inflows. The simplest example of an explicit tax is a tax on foreign exchange trading or on short-term cross-border bank loans, commonly known as the Tobin tax.
The Tobin Tax, named after Nobel Prize-winning US economist James Tobin, was proposed in 1971 for the first time with the intention to levy it on short-term capital currency transactions. At that point of time, the idea was not greeted with enthusiasm, as the 1970s were a period of optimism and confidence in floating exchange rates.
Yet, whenever currency crises have erupted during the past decades, the proposal for a levy on international currency transactions has been debated. The recent turbulence in global financial markets has rekindled interest in the so-called Tobin tax as a tool to discourage speculative currency trading and reduce exchange rate volatility.
Cross-country experience can help us look at variants of Tobin tax. An interest equalisation tax that equates the rate of return on domestic and foreign assets was imposed on capital flows in Brazil in 1993 on some classes of foreign exchange transactions. These were expanded in 1994 but were scaled down in 1995, in response to the Mexican crisis. Also, Chile and Colombia have resorted to a system of Unremunerated Reserve Requirement (URR) to discourage short-term capital inflows.
Recently, the United Kingdom called on the G-20 countries to consider such a global financial levy that would act as an insurance fee on transactions or contingent capital arrangements. Brazil recently proposed a 2 per cent tax on foreign portfolio investments to stem the rapid rise of its exchange rate. It is important to note here that the debt market is the chief concern in Brazil, since it has more debt than equity flows and a Tobin tax is more effective on debt flows.
In comparison, the Indian debt market is not as active and its capital flows are not in excess of its current account deficit. Moreover, Brazil has a rapidly strengthening trade account, based on commodities, while India’s trade deficit is improving only incrementally.
Keeping aside the economic desirability and revenue potential, its technical feasibility needs to be evaluated before India proposes such a levy.
The Securities Transaction Tax applicable on stock market transactions is a similar tax intended to discourage short-term investments. The Securities Transaction Tax levy has already been debated as being inflexible and cascading in nature, and it is for this reason that the new Direct Tax Code proposes to abolish the Securities Transaction Tax. Introduction of a similar tax on capital inflows shall only reflect a confused state of affairs.
It is also worth noting that Indian fiscal policy also provides for a higher income tax rate on short-term gains (whether or not on the stock exchange) which is not there in Brazil and in most of the countries except Australia, Germany, the US and France.
In view of this, India already has a fiscal environment to protect against short-term volatility. In addition, the implementation of such a tax may also impact genuine hedging transactions which are non-speculative in nature.
As per the United Nations Conference on Trade and Development (UNCTAD) survey, India comes third in global rankings after China and the US, when it comes to potential FDI investments during 2009-2011. Moreover, if we measure FDI inflows as a percentage of GDP, India is already receiving more inflows than Brazil, China and US.
According to International Monetary Fund (IMF), a Tobin tax might reduce market liquidity and effectively increase volatility — clearly contrary to its suggested purpose. The legislators should thus consider a Tobin tax proposal only in the event there is a similar imposition at international level as unilateral measures can prove more damaging than the exchange-rate instability they are designed to cure. Rigid controls can cut India off from economic reality, and make the country uncompetitive.
Nirmal Jain
Chairman, India Infoline Ltd
‘Overall transaction costs are what matter, not just new levies. Markets reacted badly to STT but soon got used to it — the same thing will happen with the Tobin tax’
The idea of a tax on cross-border capital flows is quite old, originally suggested by James Tobin (after whom the Tobin tax, is named) a few decades ago. In principle, a tax on capital flows is intended to curb the high volatility in cross-border capital flows. However, the idea only gained prominence during the Asian crisis when it was believed that sudden large capital outflows from the south-east Asian countries exacerbated their problems. The idea is being discussed hotly again as Brazil has introduced a 2 per cent tax on foreign portfolio flows (FDI is not covered) to curb the sharp appreciation of its currency (Brazil previously had a smaller tax that excluded stocks but was withdrawn last year when the credit crisis spread globally). UK Prime Minister Gordon Brown has also mooted a tax on financial transactions to create a pool for possible future bank bailouts. While some other European countries have supported introduction of such a tax, the US has opposed and this makes it unlikely that a global agreement on such a tax would be reached anytime soon.
We can debate the imposition of such a tax in India. One of the key arguments favouring the imposition of a tax on cross-border capital flows is that capital inflows that are far in excess of the absorptive capacity of a country can by themselves lead to a host of problems for the host countries. During 2007-08, India had a current account deficit of $17 billion (Rs 79,050 crore) while it received capital flows of over $100 billion (almost six times the requirement). Large capital flows can drive up the exchange rate of the host country making its export sector uncompetitive; an intervention by the central bank results in large increase in domestic money supply which could be inflationary and sterilised intervention has a fiscal cost. Thus there is no easy way of dealing with capital flows when they far exceed the intrinsic need of the economy. Introducing a modest tax is a relatively simple way of tempering the exuberance of foreign investors (especially speculators) in such a scenario.
One of the major concerns surrounding imposition of a Tobin tax is that if a country were to unilaterally levy such a tax, it would curtail capital inflows and hurt its growth prospects, the very reason capital is chasing those countries. An additional fear is that imposition of such a tax by some countries will result in re-routing of capital flows into more lenient jurisdictions or potentially into tax havens making financial transactions even more opaque. In our view, concerns about capital flows getting curtailed or getting re-routed are a little exaggerated. A tax like Tobin tax is principally akin to the Securities Transaction Tax (STT) currently levied in India. While initially the imposition of the STT was taken very negatively by the market, over time, Indian markets have accepted the imposition and grown manifold. Indeed, in both the cash and derivatives market, turnover growth has continued since the introduction of the STT. A key reason was the carrot of benign capital gains tax to balance the stick of STT.
Similarly in our view, from a foreign-investor perspective, what is relevant is the total cost of transacting in India (which will, in addition to a Tobin tax, include other levies like capital gains tax and STT), procedural ease and transparency. If the total cost of transacting in India is not prohibitive, the imposition of a tax on foreign portfolio flows will target only the short-term ‘hot money’ which only adds to market volatility, with little or no corresponding economic benefits. This, in fact, will help stabilise India’s financial markets in the medium term. Brazil in itself is a good example. Its equity markets, which dropped after the introduction of the tax, have outperformed emerging markets over the past couple of weeks and its currency after falling 2 per cent after the imposition of the tax, is now higher than the level before the imposition of the tax. This makes me believe that if a tax on foreign portfolio flows is levied by India (ensuring that overall cost of transacting in India is not prohibitive), it will make the market structure healthier. Such a tax must be accompanied by measures that ease flow of foreign capital and favourable changes in direct taxes. While there may be a short-term negative fallout, it may be a positive move from the long term perspective, especially in times of financial or political crisis and the consequent enormous volatility.
