SECURITY TRANSACTION TAXES AND MARKET QUALITY
by Daniel Weaver, Professor, Rutgers Business School.
In September 2009, following the financial crisis of 2008, the leaders of the G-20 countries asked the International Monetary Fund (IMF) to explore a “range of options countries have adopted or are considering as to how the financial sector could make a fair and substantial contribution toward paying for any burdens associated with government interventions to repair the banking system.”1 A financial transaction tax (FTT) is one potential instrument for raising revenue from the sector’s activities and has gained support from several G-20 countries, such as France and Germany. However, G-20 members Australia, Canada and the United States strongly oppose one. The conflicting viewpoints of G-20 member countries echoes that of theoretical economists who consider the impact of an FTT on market quality.
On the proponents side, Keynes (1936) and Tobin (1978) argue that an FTT will improve market quality. Keynes argues that an FTT will curtail short-term speculation, thereby reducing market volatility. Tobin (1978) proposes a tax on foreign exchange transactions that would make short-term currency trading unprofitable and therefore “throw some sand in the wheels of speculation.” Consistent with Keynes and Tobin, Stiglitz (1989) and Summers and Summers (1989) argue that an FTT targets short-term noise traders whose trades contribute to excess market volatility and thus will reduce overall volatility. Stiglitz (1989) further argues that although an FTT will lead to thinner markets, the impact on spreads will be insignificant.
In contrast, the opponents of an FTT argue that an FTT will have an adverse impact on market quality. Kupiec (1991) develops a model in which an FTT is directly related to excess volatility. Similarly, Amihud and Mendelson (2003) conclude that an FTT is directly related to volatility since FTTs reduce the amount of informed trading, thereby widening the gap between the transaction prices and the security’s fundamental value.
Schwert and Seguin (1993) suggest that there is no evidence of excess volatility and since the tax is a burden on all traders, the reduction in trading will not limit the activity of noise traders alone—it will affect liquidity traders and price-stabilizing informed traders as well. Thus, the impact of the tax on volatility is ambiguous. The authors also argue that an FTT will indirectly increase transaction costs. Since an FTT reduces trading volume, the number of trades available for the market-maker to recover her fixed cost declines, thereby increasing the order processing component of the spread.
While an FTT can be imposed on any financial transaction, its most common historical implementation has been on equity trades. Therefore, the bulk of empirical papers have examined the impact of a Security Transaction Tax (STT) on various aspects of market quality. Previous empirical studies examining the implications of an STT examine a quasi-tax,2 test smaller markets, or look at international market competition where a lack of fungibility inhibits the transfer of volume from one exchange to another. Further, there is no existing empirical study of the impact of an STT on equity spreads.3 My co-author, Anna Pomeranets of the Bank of Canada, and I seek to fill that void by examining the impact on market quality associated with nine changes in the level of an STT levied by New York State from its imposition in 1905 to its elimination in 1981.
As a first step in the paper, we review the empirical results of 11 papers that together examine the relationship between an STT and various measures of market quality for 28 different STT tax (and quasi-tax) changes in 11 different countries. Of the nine papers that empirically examine changes in volatility around changes in STTs, only one finds the inverse (albeit statistically insignificant) relationship predicted by Stiglitz (1989) and Summers and Summers (1989). Two papers find a statistically significant direct relationship between volatility and the level of an STT, which supports the predictions of Kupiec (1991) and Amihud and Mendelson (2003). The remaining papers either find an insignificant direct relationship or conclude that they find no relationship.
Five of the studies examine the relationship between volume and an STT. All five find evidence of an inverse relationship. However, only one is found to be statistically significant at acceptable levels. A complementary measure related to volume used in the literature is market share. Umlauf (1993) finds that an increase in a securities transaction tax is associated with a decline in market share in the domestic country.
Our paper is the first to comprehensively examine the impact of a U.S. imposed STT on various measures of market quality. In addition, unlike previous studies that observe the transfer of volume across country borders with different currencies and settlement hurdles, our dataset offers the opportunity to test the hypothesis that an increase in an STT in one geographic region shifts volume to another geographic region. Therefore, our results are applicable to countries in the Eurozone, assuming European clearing and settlement hurdles are taken down.
While advocates of STTs argue that the tax will reduce speculative trading and thus volatility, we find no consistent significant relationship between an STT and volatility. We do find, however, that an increase in the STT is accompanied by an increase in spreads. Consistent with previous literature, we find that volume moves in the opposite direction of the tax change. Finally, we find a direct relationship between STTs and price impact. Taken together, our results suggest that the imposition of an STT will harm market quality. Further, given that transaction costs are directly related to a firm’s cost of capital, we expect an STT to lead to higher capital costs. This, in turn, leads to lower firm valuations and lower investment levels which will slow down an economic recovery.
1) IMF Survey Magazine, December 1, 2009.
2) A quasi-tax is a fixed financial payment required to trade (e.g. fixed commissions).
3) Amihud and Mendelson (1992) argue that an STT of 0.5 percent will increase transaction costs. Employing a model of asset pricing with transaction costs they project that a 0.5 percent STT will increase the average firm cost of capital by 1.3 percent and reduce the average NYSE stock price by 13.8 percent.
Amihud, Yakov and Haim Mendelson. “Transaction Taxes and Stock Values.” In Modernizing U.S. Securities Regulations: Economic and Legal Perspectives, edited by Robert W. Kamphuis, Jr., 477-500. New York: Irwin Professional Publishing, 1992.
Amihud, Yakov and Haim Mendelson. 2003. “Effects of a New York State Stock Transaction Tax.” Unpublished.
Keynes, John M. The General Theory of Employment, Interest and Money. London: MacMillan, 1936.
Kupiec, Paul H. 1991. “Noise Traders, Excess Volatility, and a Securities Transaction Tax.” Finance and Economics Discussion Series 166.
Pomeranets, Anna, and Daniel G. Weaver. 2011. “Security Transaction Taxes and Market Quality.” Bank of Canada Working Paper 2011-26. http://ssrn.com/abstract=1980185.
Schwert, G. William, and Paul J. Seguin. 1993 “Securities Transaction Taxes: An Overview of Costs, Benefits and Unresolved Questions.” Financial Analysts Journal, 27–35.
Stiglitz, Joseph E. 1989. “Using tax policy to curb speculative short-term trading.” Journal of Financial Services Research, 3: 101-15.
Summers, Lawrence H. and Victoria P. Summers. 1989. “When financial markets work too well: A cautious case for a securities transaction tax.” Journal of Financial Service Research, 3: 261-86.
Tobin, James. 1978. “A proposal for international monetary reform.” Eastern Economic Journal, 4: 153—59.
Umlauf, Steven R. 1993. “Transaction taxes and the behaviour of the Swedish stock market.” Journal of Financial Economics, 33: 227-40.