Does Securities Transaction Tax Distort Market Microstructure? Evidence from Indian Stock Market

Abstract:     
Tapping into the "psychology" of the market, speculators resort to "noise-trading" rather trading on the basis of the real value of the stock and this behavior has the potential to distort the market microstructure as evidenced in most developed and developing financial markets. The popular international practice of curbing such "noise-trading" has been the introduction of securities transaction tax on a broad range of financial transactions. In consonance with the international practice and the general philosophy that financial stability should be treated as public good, Indian policy makers have introduced securities transaction tax in October, 2004 despite divergent opinions on the effect of STT on financial markets. The objective of this paper is to examine the impact of STT on market volatility and liquidity in Indian stock market. The data comprises of eleven frequently traded equity instruments listed at National Stock Exchange, India and spans over a period of 2 years before and 2 years after the introduction of securities transaction tax. Owing to the heteroscedasticity behavior of time series data, ARCH family of model is used to study the impact. The results indicate that the introduction of securities transaction tax has had no impact on market volatility and also it does not distort the liquidity in Indian stock market. Further, the result also implies an interesting fact that the informational efficiency of the market is not affected by the introduction of STT.

Keywords: Securities Transaction Tax, Market Mocrostructure, Volatility

JEL Classifications: H25, G12, G15

Working Paper Series