Taxing Financial Transactions: A Mirrleesian Approach

Taxing financial transactions is often advocated for Pigouvian reasons, when financial speculation is supposed to generate inefficiencies. We adopt instead a Mirrleesian approach, and study the optimal taxation of financial transactions when financial markets are efficient, but the tax system is imperfect, due to asymmetric information. In our model, financial transactions are used by entrepreneurs to hedge shocks on their skills, in line with the New Dynamic Public Finance literature. Entrepreneurs privately observe their skills, but trades in financial markets are publicly observable. The optimal mechanism maximizes a convex combination of utilitarian welfare and Rawlsian criterion, subject to feasibility and incentive constraints. Entrepreneurial projects are subject to liquidity shocks, which can be smoothed by conducting financial transactions. Better skilled entrepreneurs’ projects have larger expected profits, but also larger shocks. Trades therefore signal skills, implying it is optimal to tax financial transactions, in addition to capital income and wealth.