A Securities Transactions Tax and Capital Market Efficiency

PAUL H. KUPIEC ^*

This paper revisits the debate on the securities transaction tax (STT). The analysis uses Tobin ( 1984 ) taxonomy of financial market efficiency to examine the potential effects of such a tax and concludes that a STT probably would not enhance the overall functioning of financial markets.

Advocates of a securities transactions tax (STT) believe that financial markets have become too large and consume too many resources for the social benefits they produce (see, for example, Keynes, 1936; Tobin, 1984; Stiglitz, 1989; Summers and Summers, 1989). This view may have appeal in part because directly observing the social benefits that these markets generate is difficult. The opacity of benefits sharply contrasts with the transparent rent seeking that motivates market participants' activities. It is difficult to argue that society benefits greatly if a company's share price reflects new information minutes before it otherwise might have, and yet enormous profits reward the first to recognize and trade on such news. The highly publicized salaries and profits earned by financial market participants for seemingly unproductive "paper" transactions may offend many people's sense of economic justice. Indeed, the salary premium paid by the financial service sector clearly motivated the application of an STT in Sweden in the 1980s (see Umlauf, 1993 ).

STT proponents have not articulated a detailed account of how the tax will amend the alleged financial market inefficiencies they cite to garner support for the proposal. The pro-tax analysis rests on the premise that an STT will make short-horizon trading strategies unprofitable and thereby reduce trading volume and the amount of resources dedicated to these socially unproductive pursuits. Regardless of the effects an STT may have on shortterm rent seeking activities, the tax will have additional effects with potentially important economic consequences. An STT will change the relative returns on financial instruments. Such changes could favor derivative investments over cash market transactions or, alternatively, alter relative returns so that derivative transactions become altogether unprofitable. The STT may distort information flows, compromise the insurance efficiency that existing financial instruments provide, or alter the market prices of financial assets so that they less accurately reflect their underlying fundamental economic values. Such a tax may have effects on price volatility and almost certainly will alter investors' required rates of return on financial instruments.

-101-

This paper revisits the STT debate and uses Tobin ( 1984 ) taxonomy of financial market efficiency to examine the potential effects of such a tax. (See Kupiec, et al., 1993, and Schwert and Sequin, 1993, on issues surrounding the imposition of an STT in the United States and Schwert and Sequin for a recent history of STT proposals in the United States.) The analysis here considers the STT's effects on alternative measures of financial market efficiency and concludes that a STT probably would not enhance the functioning of financial markets.

In his article advocating a STT, Tobin ( 1984 ) defines a taxonomy of financial market efficiency. In subsequent sections, this paper considers how a STT might alter financial market performance as measured using Tobin's metrics of information, fundamental value, insurance, and functional efficiencies. Definitions of these alternative efficiency measures follow.

Information-arbitrage efficiency relates to the amount of information that is incorporated in relative asset prices and the speed with which relative prices adjust to new information. Empirical studies suggest that relative equity prices adjust very quickly to new public information and that little evidence exists of over-shooting in their price adjustments. A large part of the modern empirical finance literature typified by the empirical event-test methodology addresses this measure of market efficiency. (See the survey articles by Fama, 1976, 1991; Jensen, 1978.)

Fundamental valuation efficiency is concerned with how closely asset prices reflect their true economic values. Prices can be information-arbitrage efficient and simultaneously fundamental-value inefficient. If financial asset markets are fundamentally inefficient, then financial asset prices necessarily will exhibit excess volatility. Although some evidence suggests that stock market prices are too volatile to be fundamental valuation efficient, statistical complications cloud the interpretation of results and introduce reasonable doubts about claims of market inefficiency ...