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Authors:

• Junxi ZHANG
  University of Hong Kong

• Frank M. SONG
  University of Hong Kong

One of the well-known regulatory mechanisms in securities markets is the use of securities transaction tax (STT). The conventional wisdom suggests that an increase in STT reduces market volatility by discouraging the trading activity of destabilizing short-term traders. A contrarian view, however, argues that an STT may well increase market volatility due to the reduction in market liquidity and increase in the price impact of trades. This paper attempts to rationalize both views in a general equilibrium framework with noise trading. It is found that with fundamental risk and supply risk the model is able to document both the conventional wisdom and the contrarian view. To investigate the role of the two types of risks, we also consider three special cases, each with at least one type of risks missing. We find that if the fundamental risk is absent, the conventional wisdom reigns; while, if the supply risk is absent, the contrarian view prevails. But, if both types of risks are absent, which is certainly an extreme case, both views cannot be documented.