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Last week, as Rory pointed out, the idea of a Tobin tax once again appeared in popular economic discussion. This was prompted in large part because Lord Turner, the head of Britain's Financial Services Authority, re-introduced the idea of the Tobin tax as a possible way to keep the City from growing too big - and yes, 4-5% of GDP is probably too big.

So what is this Tobin tax, and does it have merit? This post will take a stab at answering these questions.

What is it?
As the name might suggest, the idea was introduced by Yale economist and Nobel laureate James Tobin in 1972.The Tobin tax consists of a modest ad valorem tax applied to certain financial transactions; proposals for taxation levels range from 0.5% to 0.01%.

The appeal of the tax is two-fold. Firstly, the flat tax would specifically target short-term capital flows. For example, if the yearly cost of a “round-trip” investment is 0.2% (a 0.1% tax, applied twice), then the monthly rate would be 2.4%; the weekly rate, 10%; and the daily rate, 48%. In other words, in order for a round-trip investment of one day to be worthwhile, the return would need to be nearly half-again as big as the initial investment. Over the span of a year, however, the tax rate is considerably less.

Why target short-term capital flows? Although opinions on this vary, one line of thinking is that the flows of short-term capital (hot money) are less productive than longer-term foreign investment. Investors are prone to herd behaviour and often lack full information. Larry Summers called them "IDIOTS" but the technical term is noise traders. Either way, the ability to move money around quickly and at low cost can produce volatility. Volatility is bad when you're trying to use foreign investments to build an economy. If that money just picks up and leaves, you're in trouble.

Indeed, it was precisely this problem which helped cause the Asian financial crisis in 1997-8: the collapse of Thailand's economy made investors panicky about the whole region and they pulled their short-run investments out en masse. At least, they pulled their money out of countries that didn't have capital controls: China, which had controls, was largely unscathed.

Insert the Tobin tax. By placing a fixed cost on the movement of money across borders, you force investors to think harder about their investments - hopefully making them more productive. The tax also provides stability by acting as a buffer against the herd behaviour of international capital markets. Moreover, the tax acts as a significant source of government revenue (which could be good or bad) and, as explained above, wouldn't scare away longer-term foreign direct investment. Great idea, right?

Will it work?
The answer depends upon what your objective is. The fact is, a flat tax on international capital movements is a pretty blunt instrument indeed. Even a 0.1% tax can be a huge cost, and could result in significant market distortions.

For instance, it's possible that a Tobin tax could punish countries that don't use major world currencies. If you want to convert Chilean pesos into Indian rupees to invest in India, you will most likely have to switch the pesos to dollars, then the dollars to rupees. With a Tobin tax in place, it's possible that this transaction will be taxed twice. Bad news for developing countries.

A similar story unfolds with international trade, where firms often hedge their contracts through spot or swap transactions. If these secondary transactions were taxed, international trade - one of the fundamental benefits of market capitalism - could be less appealing.

We could also spend a great deal of time discussing the practical difficulties of implementing such a tax. International coordination at the G20 level would be a minimum for this to be truly effective at slowing hot money and reducing volatility.

If your main concern is to generate revenue, the Tobin tax might still be a good idea. I've seen proposals for using the tax as a way to generate aid money for developing countries. Lovely notion, but Tobin himself explicitly rejected the idea of using the tax primarily as a revenue-generator because the point was to create financial stability.

But if the point is to create financial stability by limiting the size of the financial sector, as Lord Turner suggests, Willem Buiter argues that the Tobin tax is still a lousy idea. A transaction tax would not even begin address the fundamental problems in our financial markets, especially the problem of moral hazard (read his article for more detail, if you're interested).

The appeal of the Tobin tax is understandable: its beauty lies in its simplicity. But it is too blunt a tool to achieve what is being asked of it, and the G20 is rightly focusing on other issues. Nevertheless, this will not be the last we hear of the Tobin tax.