Would a Financial Transaction Tax Affect Financial Market Activity?

July 23, 2012

In the wake of the recent financial crisis, several commentators have suggested a transaction tax on financial markets. The potential consequences of such a tax could be hazardous to the financial markets affected as well as to the economy. It threatens to distort decision-making in buying and selling situations, and could also simply result in the exportation of financial markets, say George H. K. Wang of George Mason University and Jot Yau of Seattle University.

The number of pitfalls of such a tax are substantial, especially insofar as they run contrary to the very purpose of such a tax (besides raising revenue, proponents argue that such a tax policy will encourage market stability).

  • One major argument against transac­tion taxes is that a transaction tax would increase trading cost, which would reduce trading volume and market liquidity.
  • Lower market liquidity impairs market and price efficiency.
  • Additionally, a nar­rowly based transaction tax would provide an incentive for traders to migrate to an alternative domestic instrument or to un­taxed foreign markets that have lower costs.

The negative experience of Sweden, when it opted to increase its equity tax from 1 percent to 2 percent in 1986, demonstrates much of this economic loss (specifically the inadvertent exportation of financial activity to lower-cost markets abroad).

  • Steven Umlauf documented in 1993 that 60 percent of the trading volume of the 11 most actively traded Swedish share classes -- 30 percent of the total trading volume -- shifted to the London stock exchange when the Swedish transaction tax on equity increased.
  • This is corroborated by further evi­dence that commissions paid by large U.S. institutional investors when trading Swed­ish equities remained constant but the share of their taxes paid fell from 68 percent in 1987 to 13 percent by 1990.
  • That is, foreign investors, including U.S. institutions, were increasingly able to evade the tax by eliminating the use of Swedish bro­kers when trading in Sweden or by exchang­ing Swedish securities in London and New York.
  • They reported that by 1990, 50 percent of trading volume was shifted to the London equity exchange.

Thus, it seems that the implementation of a financial transactions tax would threaten participation in America's financial markets (inadvertently shifting some activity abroad) while undermining the efficiency of activity that remains.

Source: George H. K. Wang and Jot Yau, "Would a Financial Transaction Tax Affect Financial Market Activity?" Cato Institute, July 9, 2012.

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