Transaction Taxes in Limit Order Markets

In the wake of a financial crisis, regulators may consider taxing financial transactions. Recent discussions of the institution of a securities transaction tax in the United States of America have highlighted the fact that there is a gap in the knowledge of exactly how the tax would affect the market. This dissertation sets out to develop a simple model that examines from market microstructure perspective exactly how the tax would affect various market liquidity measures -- bid-ask spread, volume, fill rate, and trader profits. It also extends one of the first market microstructure models, that of Garman (1976), to see how the transaction tax would affect the survival probability of market makers. We developed a limit order book model to study the impact of a securities transactions tax on the liquidity characteristics of the market. We found that as the transactions tax increases, the bid-ask spread widened, trading volume decreased, and asset price volatility increased; we interpreted these changes as signs of reduced market liquidity. We realized that the government revenue-maximizing tax rate would stifle trading and incentives to trade. We also showed that search costs associated with waiting times between consecutive transactions increase as the probability of fill declines with the rising tax.