Gordon Brown and Nicholas Sarkozy's recent comments at the EU Summit have once again raised the idea of imposing a financial transaction levy - a broader version of the 1972 idea by James Tobin to discourage speculative behaviour by taxing foreign exchange transactions.

Whilst Brown and Sarkozy's motivation is clearly driven by the politics of extracting a greater contribution from the financial sector, the economic case for a Tobin tax rests on whether it would, in fact, stabilise financial markets. The traditional economic arguments for and against such a tax rest on the impact of the tax on market liquidity - in theory if the tax drastically reduced market liquidity it could increase volatility rather than reduce it. However, these arguments often miss the most important point. What matters is not whether the tax reduces normal market volatility by some small margin - but whether such a tax would help to prevent buying manias and selling panics.

How to address spikes in the market - an engineer's solution

Unfortunately, the Tobin Tax fails to address the problem of spikes. Taxing transactions reduces the amplitude of the price time series by a small amount but won't protect against sudden crashes or rises in the market and the resulting manias and panics. The fundamental problem with the ‘fat tailed' distributions observed in financial markets lies not with the amplitude of prices over time, but with the frequency distribution - in others words how rapidly prices rise and fall, not just how far.

The existence of spikes in a distribution reflects the presence of high frequency components in the price series. Engineers routinely remove undesired high frequency elements using "low-pass filters" - in their simplest form in electronics these take the form of inductors (tightly wound coils of wire) placed in a circuit. The resistance of the inductor is proportional to the rate of change of the current going through it - when the frequency is changing slowly resistance is minimal and the current passes through but when the frequency is high the current is blocked. A tax with the same property as an electronic inductor would help to prevent spikes.

Higher taxes during panics and manias

An inductance tax would tax transactions based on the rate of change of the aggregate market price. During normal periods sales and purchases would incur virtually no tax but during crashes sales would face heavy penalties as would purchases during booms.

By dramatically reducing the returns associated with selling during panics or buying during manias, one could substantially reduce the spikes. Spahn has already proposed something similar with his argument for a two-tier Tobin Tax. But the inductance tax has the advantage that it would not require the specification of arbitrary thresholds between the lower and upper tier tax rates.

Walk, don't run and please form an orderly queue

Although an inductance tax would be the best solution to the problem of spikes, it would be difficult to persuade market participants to pay a tax the value of which would only be known a short period in advance. Luckily there is a simple analogue to the inductance tax, which is easy to implement and is familiar to us all - queuing. Forcing people who wish to buy or sell an asset to wait in a queue is effectively a tax. The more participants who are attempting to leave (or join) the market at the same time, the longer the queue and therefore the higher the effective tax.

Of course deliberately introducing delay into trades - which, technologically, could be instantaneous - would also not be popular. However, again there is a clear analogy to this in the real world. We are all familiar with the idea that in the event of fire or emergency we should walk, not run, and form an orderly queue to leave the building. Doing so is likely to result in a better chance that everyone survives the emergency. Exactly the same thing is true in finance - forcing investors to form an orderly queue might ensure that all market participants are a little less ‘burned'.

Jumping the queue or selling your place

A final twist on the above idea takes into account that some market participants might value exiting or entering a market more highly than others. Thus it would be perfectly feasible to implement the queuing system described above, but allow those queuing to sell their places. This would ensure that that rapid exit or entry is heavily taxed, but allows those who really need to sell immediately to purchase the place in the queue of someone who doesn't mind waiting a little longer. It is also possible, with or without such trades, for people who have joined the queue to drop out. Indeed the whole point of forcing queuing is that people joining the back of the queue during a panic may give up trying to exit and, by doing so, lessen the panic.

Brown and Sarkozy would do better to focus their attention less on extracting revenue from the financial sector via a uniform Tobin Tax, and more on stabilising markets through the imposition of an Inductance Tax.

Neil McCulloch is an IDS Research Fellow in the Globalisation Team. A version of this article also appears on VoxEU

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