The Tobin Transaction Tax in Financial Markets

In 1978 James Tobin, a Nobel price laureate, published an essay about the introduction of a transaction tax on foreign exchange markets. The tax would range from 0.01% to 0.1% and would apply for the entire transaction volume of each trade. His aim was to reduce the number of speculative traders (traders who do not buy/sell currencies for bona fide commercial reasons) in the market to stabilize the traded currencies. Since then the proposal has caused controversial discussions among economists and politicians. The scientific community focuses its efforts on predicting the possible consequences of a Tobin Tax on price volatility, market efficiency, tax revenues and speculation. So far no clear cut conclusions have been reached. Among politicians the tax is presented as an instrument to fight speculation and to stabilize foreign exchange and financial markets. Beside these desired effects the resulting tax revenues play an important role for the popularity of the Tobin Tax. As a Tobin Tax has not been introduced on real world markets we investigate its consequences in economic experiments with real traders. We centre our focus on the heavily disputed effects of a Tobin Tax on price volatility, market efficiency, speculation, and tax revenues. Furthermore, we do not set up a model with only one market, but account for the fact that traders can trade the same currency on different markets. Thus they could avoid paying the tax if it is not introduced simultaneously in all markets by trading on the untaxed market. Hence, in the experiments a fictive currency is traded on two different markets. Depending on the setting a tax is either introduced or abolished on one of the markets or on both. This introduction/ abolishment leads to a change in trading behaviour and a reallocation of volume. We examine how these changes influence our key variables price volatility, market efficiency, and tax revenues. On the individual level we analyze whether the tax reduces (observable) speculative behaviour. Beside a basic control treatment we plan to conduct treatments that closely mirror market conditions. First, we examine the influence of asymmetric information and heterogeneous initial endowments on the behaviour of traders under different tax regimes. In another treatment we take into account that often transactions on foreign exchange markets are triggered by the import and export of goods. These traders cannot avoid the tax by shifting to other markets. Furthermore we investigate the effects of different tax rates on the variables of interest in another treatment. On real markets a tax cannot be introduced or abolished surprisingly from one day to another. We therefore conduct another treatment in which we announce the introduction/abolishment of the tax in advance. The Tobin Tax got more and more attention in recent years (especially among politicians) and presents a topic of international interest. Especially since the unfolding of the subprime crisis and its major impact on the world economy, banning speculation and increasing market efficiency are hotly debated issues. Clearly, due to their large trading volumes, a Tobin-Tax would harm speculators most, but the consequences on market efficiency and price volatility are unclear. With this project we aim to shed some light on these issues.

The idea of implementing a transaction tax on foreign exchange (FX) markets was first circulated by James Tobin in the early 1970s. He argued that a small transaction tax would mainly harm the frequently trading speculators which would lead to a decrease in volatility and to an increase in market efficiency. In this research project we test the impact of financial transaction taxes (FTT) on market efficiency, price volatility and trader behaviour. To address these issues we run controlled laboratory experiments. We provide several new insights to the literature. In a first study we investigate whether the trading mechanism influences market efficiency and price volatility once a FTT is applied. We show that in markets without market makers a unilaterally imposed Tobin tax (i.e. a tax haven exists) increases volatility which is diametric to the ideas of James Tobin. In contrast, in markets with market makers a unilaterally imposed Tobin tax decreases volatility, while an encompassing Tobin tax (i.e. no tax havens exist) has no impact on volatility in either setting. The reason is that market makers provide liquidity (i.e. orders to buy and sell) to the market no matter whether there is a tax or not. Therefore, taxed markets without market makers suffer from strong liquidity outflows as traders prefer the tax havens. This liquidity outflow makes the markets more vulnerable for speculative attacks which increase price volatility. Additionally, we test the impact of different taxation principles. In particular, we provide experimental evidence on the different effects of a FTT, depending on whether it is implemented as a tax on markets (i.e. all traders on a market are taxed irrespective of their residence), as a tax on residents (i.e. residents are taxed no matter where they trade), or as a combination of both. We find that the effects of a tax on markets are different from a tax on residents, with negative effects of a market tax on volatility and trading volume. The residence principle shows none of these undesired effects. In addition to studying aggregate market outcomes, we investigate how individual traders react to different forms of a FTT and whether their risk attitude is related to these reactions. We find no such relationship, meaning that a FTT affects traders with different risk tolerance similarly. To summarize, our results indicate that minor differences in implementing a FTT matter a lot for market outcomes. We therefore consider our novel results to be important for investors, politicians, regulators and for the general public. We would like to emphasize that only an encompassing FTT with hardly any tax havens would lead to at least no further undesired effects of the implementation of a FTT with the benefits of substantial tax revenues. No undesired effects can also be expected when a single country imposes the tax according to the residence principle. Otherwise, undesired effects like increased price volatility can be expected when a single country introduces a FTT according to the market principle.