Taxing Financial Transactions

Abstract: Financial markets channel savings to productive investments and provide insurance against liquidity shocks. We analyze the optimal taxation of these two activities when the government cannot directly observe agents' endowments and consumption, but only their financial markets investments and trades. The optimal mechanism maximizes a convex combination of utilitarian welfare and Rawlsian criterion, subject to feasibility and incentive constraints. We assume that the size of liquidity shocks increases with wealth, implying that the volume of financial transactions conveys information about privately observed wealth. The optimal mechanism generically involves a financial transations tax. Eliminating this financial transaction tax reduces social welfare but makes the richest agents better off.

Working paper link: Taxing Financial Transactions