Robin Hood’s dirty little secret
Fri 12 Mar 2010 by Matt Nolan.

Following the global financial crisis people all around the world were angry and they wanted someone to blame.   Given that the crisis seemed to originate from credit markets, it became natural for everyone to blame bankers.   In Britain there have been calls to make bankers pay through the introduction of a tax on speculative banking transactions called a "Robin Hood tax".   It even has the all important celebrity backing of Bill Nighy, and 131,919 fans on Facebook.   Economists have seen this tax before in a different guise – we call it a financial transaction tax.   Instead of attacking bankers, lowering financial market volatility, and raising money for the needy the burden of such a tax would fall mainly on ordinary people while having few of the claimed effects.

A financial transactions tax is a general name for a tax charged on some set of financial activities.   The British proposal targets the trading of shares, currency, and derivatives.   By doing this, proponents of the Robin Hood tax believe that bankers will be forced to pay for the current recession – leaving households unencumbered by the cost of servicing the large global deficits around the world resulting from governments propping up sick financial systems.

However, just because a tax is placed on bankers does not mean that they will face the ultimate burden of the tax, as they will typically pass on the increased cost to their customers.   Whether they can pass on the extra cost associated with the tax depends on how highly people that hire them value their services relative to the cost of their service.

If the value of financial transactions to customers is very low, the number of transactions will fall drastically as a result of the tax, leading to very little extra revenue and significant damage to the efficiency of financial markets.   If they value these financial transactions highly a lot of revenue will be raised, but a significant amount of it will becoming out of the pocket of pension funds, businesses, and small time investors that use financial services.   As a result, the tax will either destroy a significant amount of activity in the industry, or will fall on many individuals that the proponent of the tax did not mean to charge.

Although the tax is unlikely to punish bankers in the punitive way that its proponents desire, some will claim that the tax has value as it lowers the volatility of stock prices and the exchange rate.   This is because it will make it less attractive for speculators to buy and sell in financial markets.   This idea was articulated most clearly by James Tobin when trying to sell his own version of this tax – a Tobin tax.

However, this interpretation is tenuous.  According to a myriad of economic studies the introduction of a small Tobin taxis not likely to decrease volatility, and may even lead to higher volatility as traders work on the basis of larger bid-ask spreads and market liquidity dries up.

In order to side-step this criticism some supporters of a Tobin tax have stated that taxing speculative transactions will prevent bubbles so, although measured volatility might not be lower, harmful bubbles would be avoided.   This argument does not stack up either.   Although it is true that bubbles are associated with high trader volumes, these high volumes are a symptom not the cause of a bubble.   Fundamentally, a bubble involves buyers’ expectations of assets prices falling out of whack from their "fundamental value".   Taxing an asset will do nothing to prevent this from happening.

Personally, I do not blame the bankers for the crisis, and I find such punitive aims to punish them undesirable.  Instead we should be asking why the crisis happened, and if we do find issues in the credit market we should work out how to fix them at their source.

For example, the too "big to fail" creed followed by many regulators around the world ensured that large players in financial markets had, in effect, a government guarantee.   This created expectations that the downside risk from bankers’ decisions was covered by taxpayers.   As these market players received the full benefit of risky behaviour, but only paid part of the cost, there was an incentive for them to take on too much risk.   If this is the problem then we should be asking how we can ensure that market participants face the full social costs of their actions without creating undue financial market instability.

Policies such as an insurance levy, counter-cyclical capital requirements, and higher information requirements from financial firms are all attempt to do this. Although they are imperfect they could well be an improvement on bailouts for the rich that seems to be occurring at the present time.   A Robin Hood tax is punitive and poorly targeted – and as a result, is a policy that should be avoided.

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