Final answer:
Taxes used to control foreign investments are classified as political risk due to their policy-driven nature. The Tobin tax is an example of such a tax affecting international capital flows and governmental caution is advised in regards to inflows of foreign investments.
Step-by-step explanation:
Taxes must be classified as a political risk when used as a means of controlling foreign investments. This is because such taxes, like the Tobin tax named after James Tobin, directly result from governmental policy decisions. These decisions can influence international capital flows by taxing activities such as foreign exchange transactions or short-term portfolio investments, potentially exempting long-term foreign direct investment.
Moreover, regulations may be put in place to restrict foreign investment or make it difficult for international financial investors to withdraw funds. It is important for governments to exercise caution with such measures.
The reliance on short-term portfolio investment in government bonds instead of long-term physical capital investment can lead to adverse outcomes, such as a high level of foreign financial investment which may suddenly reverse if foreign investors expect a decline in exchange rates or fear government insolvency. This could result in a significant outflow of short-term financial capital, triggered by even minor negative economic news.