Would a Financial Transaction Tax Affect Financial Market Activity?

It’s no secret; the U.S. financial market has been struggling. Policymakers and economists alike have been weighing in on the issue, one which is at the forefront of the upcoming presidential election.

This has rekindled the debates on the potential costs and benefits of a financial transaction tax in the United States, and its potential impact on the futures markets. Proponents of a financial transaction tax (FTT) argue that it would increase government revenue and curb excess market volatility. Opponents of FTT argue that the tax does not necessarily reduce excessive market volatility. Instead it would adversely affect market liquidity in terms of wider bid-ask spread and lower trading volume, and may decrease transaction tax revenue.

The proposal to implement a financial transaction tax has been a popular one, but would it truly serve as the catalyst to help stabilize the markets, curb excessive financial market volatility, and raise revenue?

Dr. George WangResearch professor of finance, Dr. George H. Wang, along with Jot Yau at Seattle University Albers School of Business and Economics, recently examined the financial transaction tax in the Cato Institute’s Policy Analysis (no.702). In the analysis, Wang and Yau review and evaluate the relevant theoretical and empirical literature around the world and apply their findings to estimate the possible impact of a transaction tax on U. S. futures market activity, as well as its utility as potential tax revenue. According to Wang, one way to determine which argument is correct is to combine use of both theory and empirical data on the imposition of FTT on financial markets around the world

“There is an inverse relationship between transaction cost and trading volume—to the extent that transaction tax increases costs, trading volume will likely fall. Therefore, transaction tax revenue may even decrease,” says Wang. “There is also a positive relationship between transaction cost and price volatility, suggesting that the imposition of transaction tax may not reduce price volatility. My literature review shows that many countries that have imposed the tax have later revoked the decision because it did not yield the expected results.”

For example, Wang’s previous research shows that Singapore’s trading volume of Taiwan index futures volume was greater than trading volume in Taiwan. After the reduction in transaction tax in Taiwan futures market, the trading volume shifted from Singapore and transaction tax revenue in Taiwan actually increased two years later.

Proponents of the transaction tax maintain that its implementation will increase government revenue but Wang’s analysis points out that they are using estimations based on pre-tax trading volume.

“Current estimated elasticity of trading volume with respect to transaction tax in the U.S. futures markets is much higher than those used by the government,” argues Wang. “People will not trade as much due to the higher trading cost caused by the tax. A transaction tax on futures trading will not only fail to generate the expected tax revenues, it will likely drive business away from U.S. exchanges and toward untaxed foreign markets.”

Wang’s analysis of a financial transaction tax comes at a pivotal time for the U.S., with the Obama administration proposing a user fee in the 2012 federal budget on all futures trading and with 28 members of Congress co-sponsoring legislation also supporting a tax on futures transactions. The tax has also been proposed in Europe and India. “This is a worldwide issue right now,” says Wang, “not just a topic of interest for the United States.”

Read Dr. Wang’s Policy Analysis

George H. K. Wang received his PhD in economics and statistics from Iowa State University. Prior to join George Mason University, he was Deputy Chief Economist, Director of Market Research at U.S. Commodity Futures Trading Commission. Wang also served as Senior Financial Economist and Econometrician at Federal Home Loan Bank Board. Wang's research and teaching interests include derivatives and risk management, applied time series and financial econometrics, empirical market microstructure. He has published more than thirty papers in major refereed journals in the areas of derivative markets, applied time series, econometrics, mortgage and housing markets and transportation. Wang is an elected ordinary member of International Statistical Institute and on the editorial board of the Journal of Futures Markets. Click here for full bio.

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