Real vs. financial investment can Tobin taxes eliminate the irreversibility distortion?

• Published in: Journal of development economics 1990-04, Vol.32 (2), p.419-444
• Main Author: Tornell, Aaron
• Format: Article
• Language: English
• Subjects: Capital investments; Capital movement; Debt financing; Developing countries; Economic models; Economic theory; Interest rates; International finance; Investment; Investments; LDCs; Optimal; Production functions; Real
• ISSN: 0304-3878; 1872-6089
• DOI: 10.1016/0304-3878(90)90045-D

In the recent past several developing countries have failed to achieve significant real capital investment despite episodes of large capital inflows. Although there are real projects with seemingly high returns, investors prefer to wait for the correct time to invest. In this paper we address this issue by considering a two-sector economy where investment in real capital is irreversible and debt-financed. Furthermore, the interest rate, which is determined in the financial sector, is random as a result of volatile expectations. In this economy the expected return on real capital is above the expected interest rate. This is because the option to wait for lower interest rates has a positive value. In the presence of rumors, taxes on international financial transactions (Tobin taxes) reduce the variance of the domestic interest rate, while leaving its mean unchanged. As a result, they induce more investment in irreversible real capital. The model borrows from the irreversible investment literature. A difference with other models is that the source of noise is a mean-reverting process not just a geometric Brownian motion. We solve for the optimal decision rule using the Girsanov theorem. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity … It forgets that there is no such thing as liquidity of investment for the society as a whole. The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise … Keynes, The General Theory.