Securities Transaction Taxes and Market Quality of Equity and Futures Markets: Issues and Evidence

This paper discusses arguments for and against a securities transaction tax (STT) and evaluates the pros and cons based on a review of empirical evidence concerning the impact of STTs on equity and futures markets (i.e., trading volume, bid-ask spreads, and price volatility) and market efficiency in various countries. I find that an STT would likely reduce trading volume and increase trading cost, but may not reduce price volatility. The size of potential STT revenue depends on the STT’s impact on market activity. A sizable STT on futures and equity markets would not only fail to generate the expected tax revenue, it would also likely hurt the international competitiveness of US equity and futures markets.

In reaction to the financial crisis and government budget deficits, some members of Congress have proposed a securities transaction tax (STT) as a way to raise revenue for financing the government budget deficit or for funding regulatory agencies such as the US Commodity Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC). In general, proponents of an STT argue that it would increase government revenue and discourage short-term speculative trading, and hence, reduce price volatility. Opponents of an STT argue that it would increase the cost of capital and the cost of hedging and reduce market liquidity (i.e., cause increases in bid-ask spreads and decreases in trading volume), but would not necessarily reduce price volatility.

In this paper, I discuss rationales for STTs and evaluate arguments for and against them. I review the empirical evidence of the impact of STTs on market quality (i.e., trading volume and cost, price volatility, and market price efficiency) in different countries. Finally, I evaluate alternative methods of estimating the potential revenue from an STT.

Potential Benefits of a Securities Transaction Tax

Proponents of an STT often point to four major benefits: (1) reduced excess (short-term) speculation and price volatility, (2) reduced cost of capital, (3) increased emphasis on long-term investment results, and (4) increased tax revenue. These proponents of an STT include John Maynard Keynes, James Tobin, Joseph Stiglitz, Lawrence Summers, and Victoria Summers.

Reduced Excess Speculation and Price Volatility

Proponents of an STT distinguish between two types of traders in financial markets: value investors and noise traders. Value investors buy stocks when the market price is below the fundamental value, and they sell stocks when the market price is above the fundamental value. This value-based trading is assumed to reduce stock price volatility by pushing stock prices back toward estimates of the worth of the company. Conversely, short-term noise traders act on the basis of past price movements and seek to extract short-term gains over a long-term horizon. This type of trading may drive market prices away from estimates of fundamental values and create excess price volatility. In the literature, short-term noise traders are often referred to as small individual traders. Value investors are long-term investors who have no need to trade frequently. On the other hand, short-term speculative traders do need to trade frequently because their strategy is to follow recent price behavior. Because the trading frequency of short-term investors is much greater than that of long-term investors, the imposition of an STT would increase costs for short-term speculative traders but have less impact on the trading costs of long-term value investors. As a result, an STT would curb the frequency of short-term speculative trading and thus, theoretically, curb excess price volatility.

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