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Research Paper Series



Dale Rosenthal
Assistant Professor of Finance
College of Business Administration
University of Illinois at Chicago

Nordia Thomas
Department of Finance
College of Business Administration
University of Illinois at Chicago

UIC College of Business Administration Research Paper No. 10-13

Transaction Taxes in a Simple Price Maker/Taker Market

Nordia D. M. Thomas∗ Dale W.R. Rosenthal†

11 October 2010

In the wake of a financial crisis regulators may discuss taxing financial
transactions. Supporters suggest such a tax will deter speculation and
raise needed revenues. Opponents contend it will reduce market liq-
uidity and make trading more costly. Despite much public discussion,
there has been little theoretical examination of how markets would be
impacted. Inspired by Foucault (1999) we develop a dynamic limit
order model to study the effects of a τ per share transaction tax. The
model suggests that instituting a tax will widen spreads, reduce trad-
ing volume, and increase asset price volatility. JEL: C72, D44, G19

Keywords: transaction tax, Tobin tax, market microstructure, limit

order model.

Corresponding author : University of Illinois at Chicago, 601 S. Morgan Street (MC
294), Chicago, IL 60607. Phone: +1 312 545 4092. E-mail:

University of Illinois at Chicago

Electronic copy available at:

1 Introduction
Regulators have recently discussed taxing financial transactions. Currently
U.S. Representative Peter DeFazio is proposing a 0.25% transaction tax and
it is possible that the EU bank levy may be a transaction tax. It was also
recently reported that German Chancellor Angela Merkel “would be push-
ing for a Europe-wide financial transaction tax by 2012. . . ”1

Despite the variety of forms it may take the goal of a securities transaction
tax is to reduce price volatility, push “harmful” speculators out of the mar-
ket, encourage long-term investing and raise large amounts of revenue from
a very small tax. Supporters of such a tax claim it would throw sand in the
gears of the market to deter (presumably harmful) speculation; or, they tout
the potential revenue that could be raised and its impact on the national
budget deficit (see Eichengreen et al. (1995); Stiglitz (1989); Summers and
Summers (1989) for a review). Indeed Ms. Merkel is reported to expect the
tax to raise “an extra e2B per year for the German budget.”2

Opponents of a transaction tax argue it will lead to reduced liquidity and

make trading more costly. Many note that this increased cost will make
trading too costly for some investors. They also say it will distort the mar-
ket leading to reduced market efficiency, push traders to other venues or
countries, and it would also be difficult to implement especially across asset
classes (see, for example Habermeier and Kirilenko (2001); Campbell and
Froot (1993); Schwert and Seguin (1993)).

Though many newspaper and journal articles have been written about the
potential effects of transaction taxes no one has yet examined these effects
from a microstructure approach. Since market microstructure deals with the
details of how the market works it provides the perfect perspective on the
effect of a transaction tax on the market. We hope that the work pursued
in this paper will add a new facet to this rich literature.

We modify the Foucault (1999) price maker/taker model to allow for a range
of private valuations and quotes based on these private valuations. This al-
lows us to study the impact of a transaction tax and allows for different
types of investors. Our ex-ante expectation is that a transaction tax of τ
Peel (2010).
Peel (2010).

Electronic copy available at:

dollars/share would increase the spread by 2τ as price makers recover the tax
through their quotes. One would also expect this widened spread to yield
lower fill rates/volume, greater execution costs, and higher price volatility.
The latter is especially relevant since, as Ertürk (2006) notes, higher volatil-
ity is the opposite of the intended effect.

We find that participants who must pay a tax widen their quotes and are
less likely to trade. Instituting a 50bp tax would reduce the volume traded;
widen spreads, increasing transactions costs; and, lead to higher price volatil-

For an asset with constant value and individual preference volatility of 2.5%,
we find such a tax would reduce volume by about 20%; increase bid-ask
spreads by about 14%; increase the average price move by 8%; and, reduce
profits by about 60%. Further, each 1 bp increase in tax widens the spread
by 1.45 bp. The net result of this is that investors must increasingly be price
takers and that their transactions costs increase by 20% more than the tax.

While the results for stochastically changing asset values are not complete,
we suspect these effects would be amplified.

2 The Foucault (1999) Model

Foucault (1999) creates a simple limit order book model: A sequence of
traders enter the market, one per time period. Each trader may trade against
(take) the prevailing bid-ask quote or quote (make) a new bid and ask to
replace the prior quote. Each trade may therefore supply or demand liquid-

For simplicity, quotes last only into the following period. If a price is taken,
a price will not be made for the next period. Thus the next trader can only
quote a price. To prevent gaming, the market has an arbitrary closing time.
After each period, the market continues with probability 0 < ρ < 1.

To account for heterogeneity, a trader is one of two types: a buyer (with

probability k) or a seller. For an asset price of vt at time t, buyers value the
asset at vt + L and sellers value the asset at vt − L. Here the heterogeneous
preference L > 0 and for most of the paper Foucault uses k = 0.5.

Using this model, Foucault examines what happens under constant prices;
changing prices with competitive limit order traders; and, changing prices
with an equilibrium limit order market. In each case he calculates the bid
and ask price set by a single limit order trader (whether buyer or seller).
The difference between a quoter’s bid and ask is called the spread. The
difference between a seller’s ask and an buyer’s bid is the sum of expected
trading costs (STC) for market order traders. This is the expected cost of
entering and exiting a position for a pure price taker.

The model is beautiful and ideal in a number of ways. First, the active
choice of price taking versus price making mirrors market behavior observed
by Anand et al. (2005) and Hasbrouck and Saar (2009).3 The model also
yields other phenomena seen in markets: failure to trade because no one
of the opposite preference arrives in the market, failure to trade because
an asset’s value moves away from the prior quote, and trading because an
asset’s value moves toward a prior quote (allowing for adverse selection). Fi-
nally, because trading is not guaranteed, the model yields insight into how
fill rates/volumes are affected by changes to certain parameters.

Unfortunately, we cannot use this model verbatim to examine the effects

of transaction taxes. Since traders have only two possible heterogeneous
preferences, ±L, a tax would either have no effect or eliminate all trading.
In some cases, this incompatibility manifested itself through oddities like
spreads which narrow or even become negative in the presence of a tax.

3 The New Model

While we must depart from Foucault’s (1999) model to allow for more nu-
anced heterogeneous preferences, we continue in the spirit of his original
The fact that the model allows the trader to actively choose price taking versus price
making is very important. If the tax changes the traders’ actions, endogeneity is key.

3.1 Notation
For our modified model we need the following notation:

v = asset value (constant);

dt = heterogeneous preference of trader at time t;
δ = bid offset, amount by which market maker shades his bid;
β = ask offset, amount by which market maker shades his ask;
τ = transaction tax paid on position entry and exit;
RQ = expected quote revenue;
RQ = optimal quote revenue for next trader;
Φ, φ = standard normal cdf, pdf.

3.2 Model Dynamics

We assume that traders have heterogeneous reasons for trading and that
they have or can borrow inventory to cover a sale — there are no assumed
constraints. We first specify a non-atomic distribution for heterogeneous
preferences. Let dt be the heterogeneous preference of a trader arriving at
time t. We specify dt ∼ N (0, L2 ) for tractability (although any symmetric
distribution should proceed similarly). Thus each trader values the asset at
v + dt (demonstrating the fact that traders have a spectrum of reservation

As before the market continues in the next period with probability ρ. If a

trade occurs, each trader is debited τ per share traded. Thus any assessment
of revenue must account for paying tax at both position entry and exit. A
trader who opts to make a market will shade his quotes, he will quote a
bid of v − δ and an ask of v + β. This makes δ and β, the bid and ask off-
set respectively, functions of dt and τ ; however, their forms are not yet clear.

Traders who decide to quote, choose not to take a price offered in the current
quote. Thus they prefer the expected return of their optimal quote to the
guaranteed return of the current quote. This optimal expected return defines
the boundary between sending a market order and quoting; however, the
boundary varies with dt . This requires us to proceed in a manner different
from Foucault.

3.3 Model Statement
If v is constant, the expected quote revenue RQ is given by:

RQ = ρP (next trader sells at bid)(dt + δ − 2τ )+

+ ρP (next trader buys at ask)(β − dt − 2τ ).

The difficulty is that the next trader (at time t + 1) will decide whether to
trade against the current quote based on her optimal quote revenue. She
will do so according to the decision rules in Table 1.

Action Condition
Sell at bid 0∗
v − δ − (v + dt+1 ) − 2τ > RQ
⇒ dt+1 < −RQ 0∗ − δ − 2τ

Buy at ask v + dt+1 − (v + β) − 2τ > RQ0∗

⇒ dt+1 > RQ 0∗ + β + 2τ

Table 1: Next trader’s decision rules for placing a market order to trade
against our quote. If neither rule is satisfied, the next trader will quote her
own bid and ask instead.

Fortunately, we know nothing about the next trader and therefore assume
that the heterogeneous preference dt+1 = E(dt+1 ) = 0. We then solve for
her optimal half-spread δ 0∗ : δ = β and fixed-point quote revenue RQ
0∗ :

0∗ − δ 0∗ − 2τ
RQ = 2ρΦ (δ 0∗ − 2τ ). (2)

Using this, we can then compute our quote revenue RQ

0∗ − δ − 2τ
RQ = ρΦ (dt + δ − 2τ )+
0∗ − β − 2τ
! (3)
+ ρΦ (β − dt − 2τ ).

Since the trader wishes to optimize her quote revenue, we set the partial
derivatives with respect to δ and β to 0 and solve. This implies that the

optimal quote is to bid v − δ and ask at v + β where the bid offset is
−RQ −δ−2τ
δ =  0∗  L − dt + 2τ, (4)
−RQ −δ−2τ
φ L

and the ask offset is

 0∗ −β−2τ

β=  0∗ −β−2τ
 L + dt + 2τ. (5)
φ L

4 Exemplar Analysis
We can see what the model implies by considering a numerical example.
Suppose we have an asset with value v = $20, volatility of heterogeneous
preferences of L = $0.5(2.5%), probability of continuing to the next period
of ρ = 0.9, and dt = L. (We note that while varying dt shifted the bid
and ask, it did not change fill rates/volume, spreads, or volatility.) Results
for this conservative case with taxes ranging from $0 to $0.10 (0.50%) are
shown in Figures 1, 2, 3, and 4.
0.122 0.94



0.116 0.86

0.114 0.84



0.108 0.76
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1

(a) Bid offset (dollars) vs. tax (dollars) (b) Ask offset (dollars) vs. tax (dollars)

Figure 1: Effects of transaction taxes on the bid and ask offsets of a $20
asset with individual preference volatility of 2.5%.

We notice that the bid offset (δ) changes much less than the ask offset (β).
We see that the spread increases by 14% from $0.90 to $1.02 and that at









0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1

(a) Spread (dollars) vs. tax (dollars)

Figure 2: Effects of transaction taxes on the bid-ask spread for a $20 asset
with individual preference volatility of 2.5%.











0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1

(a) Fill rate (fraction) vs. tax (dollars)

Figure 3: Effects of transaction taxes on fill rate for a $20 asset with indi-
vidual preference volatility of 2.5%.






0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1

(a) Profits (dollars) vs. tax (dollars)

Figure 4: Effects of transaction taxes on profits for a $20 asset with indi-
vidual preference volatility of 2.5%.

τ = $0.10 the change in the spread is 1.4× the change in the tax, hence
the traderqpays 20% more than the tax. Using the Roll (1984) volatility
measure, L2 + spread2 , we see that the volatility increases from 4.05% to
4.39%; thus the average price move is about 8% larger. We also observe a
20% drop in the fill rate from 49% to 39.5%. Finally we note that profits
decrease from $0.30/share to $0.11/share, a major falloff of about 60%!

5 Summary
As mentioned before, the goal of a transaction tax is to raise revenues,
encourage longer-term investing, and curb price volatility caused by specu-
lative trading. If the proponents of transaction taxes are correct, we would
see that the imposition of a transaction tax would lead to narrower spreads,
increased market volume, and higher fill rates. Instead we find that the
institution of a 50bp transaction tax makes market participants widen their
quotes (the bid and ask offsets increase by 1.7% and 15.4% respectively); re-
duces the volume or likelihood of trading (there is a 20% decline in fill rates);
increases transaction costs (the bid-ask spread widens by 14%); greatly re-
duces the profitability of market participants (traders experience a 60% de-

cline in profits); and yields higher price volatility (the average price move
increases by about 8%).

These changes in the metrics indicate that the tax leads to reduced market
efficiency. We also note that although the effects of the tax are less for a
25bp tax (the size proposed by Rep. DeFazio), some of the changes in the
metrics such as a 30% reduction in profits are still unacceptable.4

Ertürk (2006) wrote that “[i]f the Tobin tax is not stabilizing, then much
of the rest of the discussion on its feasibility and other related issues are
probably moot.” Since one of the main thrusts of a transaction tax is to
create more stable prices, our results showing less price stability for both a
0.50% and a 0.25% tax are very thought-provoking.

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Note that this is a 30% reduction in profits, not in profits and losses (P&L). If the
full losses were added in, P&L would be further reduced.

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austerity plan.” Financial Times.

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overview of costs, benefits and unresolved questions.” Financial Analyst
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too well: A cautious case for a securities transactions tax.” Journal of
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