Some Evidence that a Tobin Tax on Foreign Exchange Transactions May Increase Volatility *

Abstract

More than two decades ago, James Tobin suggested imposing a tax on all foreign exchange transactions (Tobin, 1978). Similar proposals for imposing transaction tax on trading of other securities (see Schwert and Seguin, 1993 for a review) are also often made by eminent economists (Stiglitz, 1989; Summers and Summers, 1989). One of the putative benefits of a transaction tax is that this may decrease the volatility of prices. The intuitive rationale behind this, believed to be first articulated by Keynes in 1936, is that a transaction tax would hurt the speculators disproportionately more because they tend to trade much more frequently. An implicit assumption in this argument is that speculative trading is on average destabilizing which in turn causes prices to be more volatile. A contrasting view is offered by Milton Friedman who argued (Friedman, 1953) that rational speculators may in fact help stabilize prices. The relative merits of these opposing views can only be judged by analyzing this issue empirically. The empirical evidence on the effect of transactions taxes on volatility of prices is rare. Umlauf (1993), using Swedish stock market data from the 1980s, shows that the introduction of, or an increase in Swedish tax, led to an increase in volatility of stock prices; Jones and Seguin (1997) show that the reduction in the commission