Withholding tax may offer effective means to discourage volatile short-term capital flows

• Pages: 168-169

Page 168

Zee: A cross-border capital tax can increase the transaction costs of short-term capital movements without imperiling the attractiveness of longer-term investments.

The high costs of volatility have prompted a search for ways to discourage short-term speculative capital movements without harming longer-term investments more in tune with good fundamentals. Taxes offer one possible tool. In the 1930s, John Maynard Keynes, disturbed by the casino-like behavior of the U.S. stock market, proposed a financial transactions tax to increase the cost of speculative activities and redirect energies toward productive objectives. In response to considerable currency and capital flow turbulence in the late 1970s, James Tobin suggested imposing a tax (the Tobin tax) on all transactions involving currency conversion.

In an IMF Working Paper titled Retarding Short-Term Capital Inflows Through Withholding Tax, Howell H. Zee of the IMF’s Fiscal Affairs Department adapts the narrower goals of the Keynes proposal and suggests that countries pursuing sound economic policies and seeking to cope with large and volatile capital flow movements impose a withholding tax on all private capital inflows. Such a tax, Zee argues, would be easy to administer and difficult to evade, and would thus be more effective than the reserve requirements employed by a number of countries to impede short-term capital flows.

Tobin tax

Zee explains that the Tobin proposal, expressly designed to slow hyperactive international capital movements, taxes the amount of currency converted rather than the investment’s rate of return. The burden of such a tax varies inversely with the time period of the investment. Even a low nominal rate (1 percent or less) provides a substantial deterrent to short-term transactions but is of little or no consequence for longer-term investments.

Concerns about the Tobin tax arise, however, in terms of the practicalities of its application. The tax is designed to be administered on a universal and uniform basis on all currency conversions. Its critics contend the tax would generate large economic distortions on transactions unrelated to capital flows, require substantial international coordination to put an enforcement mechanism in place, and raise troublesome issues about the distribution of potentially large revenues among countries. Zee suggests these may be valid criticisms of a financial...