Abstract/Summary

We study the impact of a financial transaction tax (FTT) in a model that combines asset trading and real investment. An informed trader holds private information about the fundamental value of a firm, and the firm’s manager relies on the asset price to infer such information and invest accordingly. We characterize an informative, but illiquid, equilibrium where the firm’s value is optimal but trade is inefficiently low, together with an uninformative equilibrium with maximal liquidity but inefficient firm value. Although an FTT inefficiently reduces trading, it may tilt the market’s equilibrium and make asset prices more informative. We characterize the situations in which one or the other of these two effects prevails. The analysis also helps us to reconcile some puzzling empirical evidence regarding the adoption of the FTT.