Taxing short-term capital flows - An option for transition economies?

This paper discusses whether the implementation of a tax on short-term capital flows can make the transition economies of Central and Eastern Europe less vulnerable to adverse external shocks and to sudden withdrawals of foreign capital. The following section outlines the main arguments which are advanced by the supporters and opponents of a transactions tax on foreign capital flows. We also develop a simple theoretical framework which allows us to study the effects of a tax on capital inflows. The model reveals that it is important to distinguish between two effects of a transactions tax. On the one hand, a transactions tax might be a useful tool to discourage destabilizing trading strategies on the foreign exchange market. On the other hand, it should be taken into account that a tax on foreign capital flows pushes the economy to a new steady state. This induces an overshooting of the exchange rate if super efficient financial markets react faster than goods markets. Thus, the implementation of a transactions tax by itself can be viewed as a source of additional (excess) volatility of the exchange rate. Section 3 briefly discusses the experience of Chile which maintains a deposit requirement for short-term capital inflows. Section 4 gives an account of the structure of capital flows of the transition economies and of the restrictions which currently pertain to the capital account of the balance of payments. We restrict our analysis to four of the more advanced reform countries – i.e., the Czech Republic, Estonia, Hungary, and Poland – because the policy issues of high capital inflows are most relevant for these countries. Section 5 concludes.