The societal benefit of a financial transaction tax

Abstract

We provide a novel justi…cation for a …nancial transaction tax for economies, where agents face stochastic consumption opportunities. A …nancial transaction tax makes it more costly for agents to readjust their portfolios of liquid and illiquid assets in response to these liquidity shocks, which increases the demand for-and the price of liquid assets. The higher price improves liquidity insurance and welfare for other market participants. We calibrate the model to U.S. data and …nd that the optimal …nancial transaction tax is 1.6 percent and that it reduces the volume of …nancial trading by 17 percent.

On the optimal quantity of liquid bonds

“…Our paper is also related to the literature that focuses on correcting pecuniary externalities, such as Berentsen et al (2014Berentsen et al ( , 2016, and Boel and Waller (2015). Berentsen et al (2014) find that adding search frictions to a competitive secondary financial market can be welfare-improving for high inflation rates.…”

“…2 See Greenwald and Stiglitz (1986) and Berentsen et al (2016) for a more detailed discussion. 3 A detailed overview of major contributions to this field can be found in Williamson and Wright (2010), Nosal and Rocheteau (2011), and .…”

“…In each period, there are three markets that open sequentially. 8 The first market is a secondary bond market, where agents trade money for nominal bonds. The second market is a goods market, where agents produce or consume market-2 goods.…”

“…10 The necessary assumptions that make money essential are discussed in more detail in Kocherlakota (1998), Wallace (2001), Lagos and Wright (2005) and Shi (2006). A more detailed discussion about why bonds cannot be used as a medium of exchange can be found in Kocherlakota (2003), Andolfatto (2011), Berentsen and Waller (2011), Rocheteau et al (2015), and Berentsen et al (2014Berentsen et al ( , 2016. This assumption is crucial, since it allows us to break the irrelevance theorem proposed in Wallace (1981).…”

“…Using (8) to replace ∂V c 2 /∂b c , (11) to replace ∂V p 2 /∂b p , ∂K/∂b p = ∂K/∂b c = 0, and (5) updated one period, we obtain (23). Proof of Proposition 2.…”