Securities Transaction Taxes and Financial Markets
Karl Habermeier and Andrei A. Kirilenko∗
Abstract
We consider the impact of transaction taxes on financial markets in the context
of four questions. How important is trading? What causes price volatility? How are
prices formed? How valuable is the volume of transactions? Drawing on the litera-
ture on market microstructure, asset pricing, rational expectations and international
finance, we argue that securities transaction taxes “throw sand” not in the wheels,
but into the engine of financial markets. We conclude that transaction taxes can have
negative effects on price discovery, volatility, and liquidity and lead to a reduction in
the informational efficiency of markets.
JEL G13, G14, G15, G18, G28, H10, H23, H26
Keywords: Transaction Taxes, Liquidity, Market Efficiency, Distortions, Volatility
∗We thank Stefan Ingves, Patrick Honohan, Richard Lyons, and participants at the 2001 Australasian Fi-
nance and Banking Conference and 2002 World Bank Workshop on the Taxation of Financial Intermediation
for helpful comments. The views expressed in the paper are our own and not necessarily the official position of
the International Monetary Fund. Contacts: Karl Habermeier and Andrei Kirilenko, International Monetary
Fund, Washington, DC 20431. Fax: (202) 623-8863, E-mail: akirilenko@imf.org, khabermeier@imf.org.

1 Introduction
Financial markets transform latent demands of investors into realized financial transac-
tions. Securities transaction taxes (STTs) alter this transformation. Proponents of STTs
argue that such taxes can reduce market volatility, help to prevent financial crises, and re-
duce excessive trading.1 Opponents believe that STTs are difficult to implement and enforce
and that they can do great damage to financial markets.
This paper considers the impact of transaction taxes on financial markets in the context
of four broad questions. How important is trading? What causes price volatility? How are
prices formed? How valuable is the volume of transactions? These questions are at the core
of the debate on the role of transaction taxes. Our arguments draw on research on market
microstructure, asset pricing, rational expectations, and international finance.
Market microstructure studies suggest that trading is essential for price discovery - the
process of finding market clearing prices. A large number of markets rely on dealers to
provide price discovery as well as liquidity and price stabilization. Levying STTs on the
dealers inhibits their ability to assist investors with the transformation of latent demands
into realized transactions. The literature also finds that much of the volatility is caused by
informed traders as their information is aggregated into transaction prices. Taxing financial
transactions does not reduce the volatility due to “noise” trading. Rather, it introduces
additional frictions into the price discovery process.
The literature on option pricing under transaction costs shows how frictions on the trading
in one asset affects prices and volumes of that and other assets. Using a simple framework
based on this literature, we show that the volume migrates to the assets that are not subject
to the tax. We also argue that it is very difficult to design and implement a tax that does
not favor one portfolio of assets over another portfolio with exactly the same payoff.
Recent studies on rational expectations question the traditional view that volume is
just an outcome of the trading process and is not valuable per se. These studies find that
volume can play an informational role. Consequently, if transaction taxes cause the volume
to migrate, then they can hamper the informational efficiency of markets.
International finance provides other interesting examples of volume fragmentation and
market segmentation. Volume fragmentation can occur due to restrictions on trading of
substitutable securities such as different share classes. This leads to market segmentation
and inefficient price discovery.
Overall, there are strong arguments that transaction taxes can have negative effects on
price discovery, volatility, and market liquidity. These effects can lead to a reduction in
market efficiency and may contribute to increased volatility.
This paper is organized as follows. Section 2 reviews the literature on STTs. Section 3
1For example, Eichengreen, Tobin, and Wyplosz (1995) argue that “transaction taxes are one way to
throw sand in the wheels of super-efficient financial vehicles.”
1