Tobin’s Trading Tax Raises Volatility!

Every financial crisis brings forth calls for a tax on financial transactions. Sarkozy and Merkel are backing the current push. The rationale for this is based on James Tobin’s argument that trading leads to volatility – therefore, a tax on trading should reduce turnover and in turn reduce volatility…

Wrong! The counter to this argument is that a trading tax impedes the efficient application of arbitrage mechanisms, thereby allowing market prices to wander away from fair value. A practical example is the ETF market where market makers are able to buy physical stocks and sell the ETF when the ETF trades at a premium and vice versa when at a discount. Transaction costs determine the bounds within which physical and ETF prices may diverge before triggering the arbitrage trade. Imposing an additional trading tax would widen this ‘train-track’ range thereby permitting prices to wander further.

Tobin’s argument assumes that most trading activity is speculation. In fact, most trading is hedging, strategic rebalancing and arbitrage related. Widening the train-tracks simply increases the volatility bands…equally, it forces investments to find untaxed environments. No wonder the British have rejected the EU’s push for a trading tax…