Financial Transaction Tax: Policy Analytics Based on Optimal Trading

Abstract

Introducing a financial transaction tax (FTT) has recently attracted tremendous global attention, with both proponents and opponents disputing its dampening effects on financial markets. In this paper we present a model to show under some circumstances that there exists a win-win situation via optimal trading when the tax burden can be dispersed. The way to absorb FTT in our model is to adjust the bid---ask spread. In our optimal trading model that considers FTT, the representative traders depend on the liquidity (market depth) they supply to weight their associated transaction cost by adjusting the spread ex post. We illustrate the analytical properties and computational solutions of our model when finding the optimal trading strategy under different market situations in order to offset FTT. We also conduct a simulation study to show the superior performance of our proposed optimal trading strategy in comparison to the alternative strategies that do not consider absorbing FTT. The results demonstrate that there is indeed a win-win situation, because financial institutions will not be worse off if such an optimal trading strategy is applied to offset FTT and reduce their transaction cost.