Transaction Tax and Market Quality of U.S. Futures Markets: An Ex-Ante Analysisi

Abstract

In this paper, we analyze the impact of a transaction tax on the market quality of U.S. futures markets by estimating the elasticity of trading volume and of price volatility with respect to bid-ask spread in a three-equation model framework for eleven financial, agricultural, metals, and energy futures for the period 2005-2010. We find that: (1) Trading volume has a negative relationship with bid-ask spread and a positive relationship with price volatility after controlling for other factors; (2) Bid-ask spread has a negative relationship with trading volume and a positive relationship with price volatility; and (3) Price volatility has a positive relationship with bid-ask spread and with trading volume after controlling for other variables. We demonstrate that a transaction tax, which is analogous to a bigger bid-ask spread, will drastically reduce trading volume if the tax constitutes a significant increase in the total fixed trading cost, and/or the elasticity of trading volume with respect to transaction cost is high enough. Thus, a transaction tax may not raise substantial revenue for the government as suggested in other studies.