1. The economic consequences of a Tobin Tax – An experimental analysis Michael Hanke* Jürgen Huber* Michael Kirchler* Matthias Sutter*,# * University of Innsbruck # University of Göteborg ESA World Meeting Rome 2007

2. Outline Motivation Experimental design and procedure Effects of the introduction of a Tobin Tax on –Trading volume –Market sharesthe “trivial“ issues –Tax revenues –Volatility –Market efficiencythe “disputed“ issues –Individual trading patterns Conclusion

3. Motivation James Tobin proposed a transaction tax on foreign exchange markets in the 1970ies. Alleged effects: –reduces short-term speculation –reduces volatility (stabilizes markets) –tax revenues (often downplayed as “side-effects”) Hard facts missing – the introduction of a Tobin Tax is still discussed. Run an experiment to clarify the “disputed” issues.

4. The issues The “trivial” issues (Haq et al. 1996; Weaver et al. 2003): –Market volume is expected to decrease – since those who do not trade for bona fide commercial reasons might be driven from the market. –The market shares of taxed markets – in relation to tax havens – should decrease due to tax avoidance. –Tax revenues should accrue, but due to tax avoidance they should be smaller than naïve estimates would predict. The “disputed” issues: –Volatility: Up or down (Aliber et al. 2003 or Hau 2006 vs. Westerhoff 2003 or Ehrenstein et al. 2005). –Market efficiency: Up or down (Ehrenstein 2002 or Westerhoff 2003 vs. Kupiec 1995 or Subrahmanyam 1998). –Individual trading patterns: Which trader types are affected? (Bloomfield et al. 2006 – examination of tax havens missing)

5. Experimental design Two markets (LEFT and RIGHT). Two currencies (GULDEN and TALER). –Both currencies are tradable on both markets (Gulden as home currency). –Continuous double auction markets (100 seconds per period). –Limit and market orders without restrictions. –Short selling is prohibited. –Switching between markets costless. 20 traders. Initial endowment of 8,000 GULDEN and 200 TALER (worth 40 GULDEN each). 18 periods. No interest is earned on any currency Fundamental value of Taler revealed at the beginning of each period. Fundamental value follows random walk.

6. Designing the treatments Periods 1-6: no tax on either market. Periods 7-12: a two-way transactions tax of 0.5% is introduced … –on one market  other market is tax haven; –on both markets  encompassing Tobin Tax. Periods 13-18: –if previously introduced on both markets, the tax is removed in one market; –if previously introduced on one market, it is … either removed there, or introduced in the other market as well.

7. Balanced treatments Periods 1-6 Periods 7-12 Periods 13-18 TreatmentLEFTRIGHTLEFTRIGHTLEFTRIGHT 0L0--Tax--- 0R0---Tax-- 0L2--Tax- 0R2---Tax 02L--Tax - 02R--Tax -

8. Trading screen

9. Some intuitive illustrations Econometric estimations Results

10. In general, very active trading overall (one transaction every two seconds). Unilateral introduction of Tobin tax on one market leads to a huge drop in trading volume. Most of this drop is due to a shift of trading to the untaxed market (the “tax haven”). An encompassing introduction of the Tobin Tax on both markets reduces trading volume by about 25%. Trading volume

12. Market share In the first 6 periods of each market, conditions on both markets are completely identical. However, market shares are strikingly different: –68% of volume on LEFT, –32% of volume on RIGHT. This endogenously evolved pattern creates a perfect opportunity to study how a Tobin Tax interacts with the relative size of the taxed market.

13. Market shares in “010”-markets Market share of LEFT market “0L0”: Huge drop of LEFT after period 6. Loss of market share not fully regained after period 12. “0R0”: Large drop of RIGHT first, but losses fully regained after period 12. LEFT taxed RIGHT taxed Tax removed

14. Market shares in “012”-markets Market share of LEFT market “0L2”: Huge drop of LEFT after period 6. Loss of market share not fully regained after period 12. “0R2”: Hardly any influence on RIGHT after period 6.

15. Market shares in “021”-markets Market share of LEFT market “02L” and “02R”: Taxed market after period 12 has less than 10% of market share.

16. Tax revenues Trade volume before the introduction of the tax is a very bad predictor for the tax base after the introduction of the tax.

17. How we measure the “disputed” issues Volatility: Absolute returns in %. Market efficiency: Mean Absolute Error (MAE) of prices and fundamental values (provided to traders). Speculative trading: Relative frequency of switching from buyer to seller position and vice versa within a given period (fundamental value does not change within period).

18. Econometric estimations T b … dummy if both markets taxed T t … dummy if market taxed, but other one untaxed T u … dummy if market untaxed, but other one taxed

19. Conclusion If introduced unilaterally, the Tobin Tax causes a dramatic shift of trading volume to the untaxed market. The taxed market loses a large share in market volume, in particular if the large market is taxed. Tax revenues are smaller than naïve estimates would predict. Volatility is reduced if both markets are taxed – or in the untaxed market, if the other is taxed. Market efficiency increases, expect in the taxed market when the other one is untaxed. Speculation is reduced in taxed markets, but it shows up again in untaxed markets.

20. Thank you very much for your attention!

21. Appendix (on request)

22. Main results on “disputed” issues Volatility –If only one market taxed, volatility does not decrease in the taxed market, but rather in the untaxed one (due to a large shift of trading volume to the untaxed one). –If both markets are taxed, volatility decreases (rather sharply). Market efficiency –If only one market taxed, market efficiency increases in the untaxed market (due to speculators shifting to this market), but stays the same in the taxed market. –If both markets are taxed, market efficiency increases.

23. Main results on “disputed” issues Speculative trading –If only one market taxed, speculation is sharply reduced in the taxed market (due to massive trading shifts), but is increased in the untaxed market (speculators show up again). –If both markets are taxed, speculation is significantly reduced, but not by very much.

24. Sample transaction plot of a 010 market where a tax is introduced on the LEFT market in periods 7-12

25. Number of trades Large LEFT market taxed in periods 7-12 If taxed, the large LEFT market loses a lot of trades. The previous level is not regained if the tax is removed or the other market taxed as well. Same results apply to market shares.

26. Number of trades Small RIGHT market taxed in periods 7-12 If taxed, the small RIGHT market loses some trades. The previous level is fully regained if the tax is removed or the other market is taxed as well. Same results apply to market shares.

27. Number of trades Tax removed on one market in periods 13-18 Large shift of trading activity if an encompassing Tobin Tax is removed in one market only.