One Fundamental and Two Taxes: When Does a Tobin Tax Reduce Financial Price Volatility?

60 Pages Posted: 19 Mar 2014

See all articles by Yongheng Deng

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison

Xin Liu

National University of Singapore (NUS) - Department of Finance

Shang-Jin Wei

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); International Monetary Fund (IMF); Tsinghua University - School of Economics & Management

Date Written: March 2014

Abstract

We aim to make two contributions to the literature on the effects of transaction costs on financial price volatility. First, by using a research design with three ingredients (a common set of companies simultaneously listed on two stock exchanges; binding capital controls; different timing of changes in transaction costs), we obtain a control group that has identical corporate fundamentals as the treatment group and is therefore far cleaner than any in the existing literature. We apply the research design to Chinese stocks that are cross-listed in Hong Kong and Mainland. Second, we entertain the possibility that a given transaction cost can have different effects in immature and mature markets. In an immature market where trading is dominated by retail investors with little knowledge of accounting and finance, a Tobin tax should have the best chance of generating its intended effect. In a more mature market, higher transaction costs may also discourage sophisticated investors, hence impeding timely incorporation of fundamental information into prices. We find a significantly negative relation in the Chinese market, on average, between stamp duty increase and price volatility. However, this average effect masks some important heterogeneity. In particular, when institutional investors have become a significant part of traders' pool, we find an opposite effect. This suggests that a Tobin tax may work in an immature market but can backfire in a more developed market.

Suggested Citation

Deng, Yongheng and Liu, Xin and Wei, Shang-Jin, One Fundamental and Two Taxes: When Does a Tobin Tax Reduce Financial Price Volatility? (March 2014). NBER Working Paper No. w19974. Available at SSRN: https://ssrn.com/abstract=2411277

Yongheng Deng (Contact Author)

Wisconsin School of Business, University of Wisconsin-Madison ( email )

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Madison, WI 53706
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HOME PAGE: http://https://bus.wisc.edu/faculty/yongheng-deng

Xin Liu

National University of Singapore (NUS) - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore
+65-8337-9470 (Phone)

Shang-Jin Wei

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

International Monetary Fund (IMF)

700 19th Street, N.W.
Washington, DC 20431
United States

Tsinghua University - School of Economics & Management

Beijing, 100084
China

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