The Telegraph
Since 1st March, 1999
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Indians, particularly those trading domestic currency, may find the cash withdrawal tax introduced by the finance minister, P. Chidambaram, in the budget for 2005-06 uncomfortable. Yet, the finance minister has merely adopted the Tobin tax principle.

The currency transaction tax or the Tobin tax has a chequered history. The noted economist, the late James Tobin, propounded the principle of CTT in 1972. It later found favour with other economists. In recent years, no discussion on global social development is complete without a discussion on the Tobin tax.

The Tobin tax is based on the reasoning that money has become a commodity rather than a means of exchange. Given the fact that trading volume in currency globally exceeds US $ 1.2 trillion a day, estimates of aid that could be raised by imposing a Tobin tax vary between $50-250 billion per year, based on tax rates between 0.05 per cent and 0.25 per cent.

Tobin first floated the idea of a CTT in 1972, as a measure to enhance macro-economic efficiency, but did not find takers. Five years later, he made it the central theme of his presidential address at the Eastern Economic Association, but in Tobin's own words, 'it sank like a rock'. The central banks hated it. They saw it is as an impediment to free trade. The only interest came from journalists and financial pundits, who saw it as a panacea to global financial volatility such as the Mexican crisis and the east Asian meltdown.

The Nineties however changed all that. The former French president, Francois Mitterand, set the ball rolling at the World Social Summit at Copenhagen in 1994. Instead of focussing on the economic efficiency enhancing capacity of CTT, he took off on the revenue-generating potential of the tax, which Tobin outlined as one of the by-products, rather than its main characteristic. Mitterand's suggestion of a Tobin tax for multilateral purposes caught the popular imagination. The issue came up again for discussion in March 2002, when the heads of state and major international institutions met at the United Nations Financing for Development Conference in Monterrey to discuss ways to reduce global poverty.

In 2002, the United States of America scuttled a move for a global CTT, but in February 2004, Chaka Fattah, a US representative and five-term democrat from Philadelphia, moved a bill seeking to replace the existing federal tax on income and profits with a transaction fee, akin to the CTT. The proposal was shot down, but in July 2004, Belgium became the first country to adopt the CTT. In January 2005, in his speech before the World Economic Forum, the French president, Jacques Chirac, again suggested a cross-border tax to deal with natural calamities, disease, want and violence. Clearly, the Europeans are more inclined towards what the US political leadership is reluctant to allow.

From an Indian perspective, the Fattah and Belgium models are relevant, as they throw light on what the Indian finance minister is trying to do. The Belgian model builds the tax structure around the dual goals of raising revenue for aid under normal circumstances and imposing a deterrent tax on foreign exchange transactions during periods of volatility. In keeping with these goals, it has a two-tiered tax structure. During periods of normal currency trading, traders have to pay one basis points of all currency trades at the point of settlement as CTT. However, when the market is volatile, a punitive rate, as high as 80 per cent, comes into play, wiping out all speculative gains.

Under the Fattah model, the transaction fee would apply to any transaction that uses any form of payment ' cash, cheques, credit cards, transfers of stock, and so on. It would be collected on all retail and wholesale sales, all purchases of goods and all financial transactions. Only cheques or electronic transfers issued by employers for their employees' salaries would be exempt. To allow for flexibility, the model offers three fee structures for the US administration to choose from. Under the first structure, all cash transactions below $ 500 would be exempt. Alternatively, the government could consider fixing a flat rate as a fee, or it could adopt a progressive rate, taxing higher value of the transaction at higher rates, which would be similar to our income tax slabs.

Interestingly, underlying both the Belgian and Fattah models is the principle that for the CTT or its equivalent to work, the rate of tax has to be marginal. Many of Tobin's detractors had argued that the CTT would result in driving away currency trade from CTT-imposing countries to others, or in the migration of currency from tax to non-tax trades, and prove to be a deterrent to commodity trade and long-term foreign investments. To silence such criticism, Tobin forwarded a calculation: a 0.2 per cent tax on a round tripping to another currency (selling and buying back the same currency within a short period of time) would cost 48 per cent a year if transacted every business day, 10 per cent if every week and 2.4 per cent if done every month. Tobin argued that at these rates, it was a trivial sum of tax on commodity trade or long-term foreign investment, though it would be substantial ' and thus a deterrent ' on round-tripping.

Chidambaram is using the same technique to curb black money transactions with his cash withdrawal tax, though he is neither explaining issues as succinctly nor is he using the revenue argument to impose the tax. The departure lies in the fact that the Indian tax is not on foreign but domestic currency transactions. Yet, in keeping with the Tobin tax principle, the rate of tax is marginal. Hence, its impact should be negligent on cash withdrawals for legitimate purposes, though it would be substantial on money launderers, who could be withdrawing white money to fuel black money transactions and laundering it back into white through the banking system. For want of other parameters, if one were to extrapolate Tobin's calculations, one could assume that a 0.1 per cent tax on cash withdrawals could translate itself into 24 per cent tax when the cash is round-tripped every working day, 5 per cent every week and 1.2 per cent every month. Evidently, even if these calculations are approximations, trade ' which constantly rotates cash but often does not pay taxes by underestimating incomes by maintaining dual accounts ' understands these dimensions only too well.

The opponents of the cash withdrawal tax have argued that it is detrimental to honest taxpayers. Arguments have also been extended that hospitals and colleges don't accept cheques ' but then isn't it time they did, unless their intent is to dodge taxes' Further, lobbying is on to get withdrawals of fixed deposits on maturity, bearer cheques, bank draft, and so on, out of the net. Yet, this is exactly what Chidambaram cannot do. The beauty of CTT lies in its simplicity. It is a single parameter tax and exemptions would only spoil its structure as well as render it less ineffective. Hence, what is feasible is raising the threshold for exemption from Rs 10,000 to higher levels. That would ensure that the concept of CTT is well entrenched in the Indian tax tomes, even while goals of deterring black money generation and raising revenue for development are met.

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