Financial Transaction Tax, macroeconomic effects and tax competition issues: a two-country financial DSGE model

We document how introducing a financial transaction tax affects real and financial activity in a general equilibrium framework. Our model replicates some interesting stylised facts about financial markets. Informed, or rational, traders follow the standard rational expectations, while exogenous disturbances, such as optimism or pessimism shocks, affect the expectations of noise traders. An entry cost is introduced to endogenise the entry of noise traders in the financial markets. In contrast to the previous literature, financial contagion and international spillovers are considered in a two-country financial DSGE model. A welfare analysis is performed and we show that the effects of the financial transaction tax on welfare are non-linear and mainly depend on the composition of the financial market. In addition, introducing a financial transaction tax allows volatility to be reduced in both the real and financial sectors, and this result is robust to several model specifications. In a context where only one country implements the tax, we identify some externalities, as the country with the tax is likely to export stability or instability through the flows of traders. Like in the Heckscher-Ohlin-Samuelson (HOS) model in which capital and labor move internationally when countries trade, we assume that there are trader flows when traders invest abroad. As a consequence, noise traders can implicitly move to the foreign country to escape the tax, and this means that countries have conflicting interests. When markets are liquid with a large proportion of noise traders, countries do not internalise that they export noise traders and then some instability to the other market and so they set a tax rate that is higher than the optimal. At the opposite end of the scale, when markets are less liquid and the proportion of noise traders is small, some positive externalities (like financial stability) are overlooked, and so the tax rate is set too low and is sub-optimal. A cooperative situation where countries set a common tax rate is the best solution ans is welfare-enhancing. These results have important policy implications, since the existence of the tax competition issues revealed by our two-country framework might explain why the European Commission proposal initially discussed in 2011 is so contested and has been rejected by several countries.