The Benefits of a Financial Transactions Tax
This could potentially be a very large benefit from an FTT. If it reduced trading volume by 25 percent (the middle scenario in Pollin et al.), leading to a corresponding reduction in resource use, it would free up more than $60 billion a year in labor and capital for productive uses. 5
Whether or not reduced trading leads to serious harm to financial markets would depend on its impact on liquidity and market volatility. Obviously the tax will reduce liquidity by reducing the volume of trading, but it is not clear that the impact will have much consequence. For example, if trading of the most liquid assets, like government bonds, were cut by 50 percent, or even 75 percent, these assets would still have enormous markets. Such reductions in trading may reduce the volume to levels of 20-25 years ago, but these markets were already highly liquid in the 80s.
The tax will also affect trading in less liquid assets, but one of the advantages of the structure of the tax is that the proportionate increase in trading costs will almost always be smaller on less liquid assets, since these assets almost invariably have higher bid/ask spreads. In the case of equities, the tax may double the transaction costs for the most frequently traded stocks, the proportionate increase in trading costs will be far smaller on less frequently traded stocks, and therefore the proportionate reduction in trading volume would be lower.
The impact on volatility is also ambiguous. Theoretically, the impact can be in either direction. If all market actors arrived at their assessments of assets independently, then an FTT would by definition increase volatility, since it would reduce trading volume and therefore the number of independent assessments among traders. However, if there are substantial numbers of noise traders (traders who act based on market movements rather than an assessment of fundamentals) in the market, the reduction in trading volume could actually reduce volatility since it can prevent price swings driven by momentum rather than fundamentals.6 The research on the relationship between trading volume and volatility is ambiguous. In short, it is reasonable to believe that the reduction in trading volume that would follow from the imposition of an FTT will not qualitatively change the degree of volatility in financial market.
Financial transactions taxes have been a widely used source of revenue in the United States and elsewhere in the world. A set of taxes applied to trading in a broad range of financial assets and scaled to the level of the UK stamp tax on stock trades could raise close to $100 billion a year in revenue in the United States. Such a tax is arguably efficiency-enhancing since it would substantially reduce the resources used by the financial sector without reducing its effectiveness in allocating capital.
This calculation assumes that the securities and investment sector’s share of private sector output is equal to its share of private sector wages and that its size shrinks by 25 percent as a result of the imposition of a FTT. For a theoretical discussion of noise trading see Delong et al. 1987.