Introducing a financial transaction tax on all trades by residents in a particular jurisdiction would be preferable to a tax on all trades in a given market. That is the conclusion of experimental research by Juergen Huber, Michael Kirchler, Daniel Kleinlercher and Matthias Sutter, published in the October 2017 issue of the Economic Journal.
Their study, which uses the laboratory as a ''wind-tunnel for new regulation'', indicates that a financial transaction tax implemented through a ''residence principle'' causes far fewer market distortions and volatility than implementation through a ''market principle'', with the additional benefit of substantial tax revenues.
The researchers note that the idea of a financial transaction tax is fiercely contested: dubbed the ''Robin Hood tax'' by its supporters, but viewed by opponents as threatening to cripple the financial sector.
What''s more, as 11 members of the European Union have committed to implement a financial transaction tax by 2019, discussions about its likely effects have gained momentum – not least with the recent renewed call for such a tax by French president Emmanuel Macron.
Yet since a financial transaction tax has rarely been implemented in practice, evidence on its potential impact is still very limited. To date, academic debate has missed some important institutional details, which is why it cannot provide unambiguous evidence as a basis for political debate.
In particular, previous research on financial transaction taxes has ignored the precise taxation scenarios, in particular whether the tax is implemented on all trades in a given market – the ''market principle'' – or on all trades by residents in a particular jurisdiction – the ''residence principle''.
The new study examines the likely consequences of different institutional settings by inviting a total of 480 participants to trade on their laboratory asset markets. In the experiment, participants could trade assets for money in two independent jurisdictions, each with one financial market, under a number of different taxation scenarios:
• a tax on residents;
• a market tax;
• a combination of a market tax and a tax on residents within the same jurisdiction;
• or a tax on residents for one jurisdiction and a market tax on the other.
The study finds a significant shift in trading volume when the market principle is applied – that is, when all transactions in one market are taxed, while the other market is not taxed. About three quarters of trading in the taxed market shifts to the untaxed alternative. With liquidity in the taxed market evaporating, volatility increases significantly, leading to the opposite effects of the tax to those originally intended.
In contrast, applying the residence principle – meaning that all trades of residents of one jurisdiction are taxed, irrespective of whether they trade on their home market or on the foreign market – has no significant effects on trading volume or volatility. Thus, it causes practically no distortions in the markets and the tax revenues are substantial.
In addition to disentangling the effects of a market or residence principle, another contribution of this study is to show how individual traders with different attitudes towards risk are influenced by the introduction of a financial transaction tax. The findings indicate that risk attitude is irrelevant for a subject''s reaction to such a tax: risk-seeking and risk-averse traders are equally affected by its introduction.
Overall, the study provides the basis for advice to policy-makers, as it clearly shows that a financial transaction tax implemented through a residence principle causes far fewer market distortions than implementation through a market principle, with the additional benefit of substantial tax revenues.
''Market vs Residence Principle: Experimental Evidence on the Effects of a Financial Transaction Tax'' by Juergen Huber, Michael Kirchler, Daniel Kleinlercher and Matthias Sutter is published in the October 2017 issue of the Economic Journal. Juergen Huber, Michael Kirchler and Daniel Kleinlercher are at the University of Innsbruck. Matthias Sutter is at Max Planck Institute for Research on Collective Goods Bonn and University of Cologne.