Taxing finance
What’s at stake: The flurry of interest on ways to tax the financial sector has continued this week as the Obama administration announced on Friday its intention to propose a Financial Crisis Responsibility Fee that would require the largest and most highly levered Wall Street firms to pay back taxpayers for the extraordinary assistance provided. European leaders have so far opted for a supertax on bankers’ bonuses and explicitly encouraged the IMF to consider the introduction of a global financial transaction tax at a recent EU summit.
The Economist's Free Exchange blog gives the motivation for the tax over and above the desire to recoup the money spent bailing the banks out. The administration is clear in its desire that this function as an incentive for banks to get smaller and less leveraged. The fee President Obama is proposing would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms – excluding FDIC-assessed deposits and insurance policy reserves, as appropriate – the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt. Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions. What's mystifying, then, is that the fee will only apply until TARP has been repaid.
Gregory Mankiw says that if well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts. The problem of implicit subsidies is widespread as we have in effect turned much of the financial system into government-sponsored enterprises. We could promise never to bail out financial institutions again. Yet nobody would ever believe us. And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time. Alternatively, we can offset the effects of the subsidy with a tax. It is possible that it will be better than doing nothing at all, watching the finance industry expand excessively, and waiting for the next financial crisis and taxpayer bailout.
Simon Johnson writes that the right way to tax finance going forward is with an “excess profits tax”, where the target is not profits per se, but high profits made by individual banks that are big relative to the system. Imposing an excess profits tax will not be easy – there are too many ways to game the system – and, at a minimum, an effective tax will require a high degree of cooperation at the level of the G20. The good news is that the G20 has tasked economists and lawyers, in and around the International Monetary Fund, with the job of designing a system that will minimize evasion; the bad news is that this will take a year or two to come on-line, and even longer to become properly effective. In the meantime, the least worst way to prevent excessive risk-taking is to focus on bonuses at banks with at least $100 billion in total assets.
Luigi Zingales proposes a Tobin tax on short-term debt. By taxing the use of short-term debt (let us say with maturity of less than a year), we discourage both excessive leverage and use of short-term leverage, preventing a crisis. Anticipating this risk, why did financial intermediaries choose to borrow so much in the short term? Because it allowed them to borrow more and borrow more cheaply, increasing profits. Short-term lenders, meanwhile, felt confident that they could get out of troubled companies in time. But while the exit option is available to each lender individually, it is not available to all lenders together. When all short-term lenders try to leave, not only can they not do so, they precipitate a crisis. In other words, the incentives to borrow short-term exceed what would be optimal from a social point of view. This is a typical situation where a tax can fix the problem.
Charles Goodhart makes the case against a Tobin tax. Goodhart says that the proponents of the Tobin tax mistake the fact that commercial end-use of foreign exchange (fx) dealing is not more than about 10%, at most, of the total of fx transactions into a belief that the other 90% is a form of ‘socially useless’ speculative froth, which could, and should, decline without real loss. Counter-intuitively, Goodhart argues, the introduction of a Tobin tax could even raise the ratio of purely speculative to commercial and legitimate end-use operations in those financial markets to which it was applied.
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