Taxing spoils of the financial sector
If you want less of something, tax it.
That truism is often used as an argument against a tax on profits, or health benefits, or employment, but in the case of the rents extracted from the economy by the financial services industry here’s hoping it proves more of a promise than a threat.
The International Monetary Fund has put forward two new taxes on banks to pay the costs of future rescues, one of which is a fairly conventional “Financial Stability Contribution,” with an initial flat levy on all banks, to be refined later into something with more precise institutional and systemic risk adjustments.
More interestingly, the IMF is also proposing a “Financial Activities Tax,” (FAT) a tax on bank pay and profits which, if correctly designed, could serve as a tax on rents — the unwarranted spoils — of the financial sector.
In economics the concept of “rents”, essentially the extra money a given individual or industry is able to extract from its clients above what it would if there were perfect competition, is central. If there is only one cable television provider in your neighborhood you will know what I am talking about.
In financial services, the evidence is that rents are huge, in part because of impaired competition and in part because increasingly complex financial services allow banks to sell clients products that they don’t understand, may not need and will almost always be over-charged for. Bank employees in turn charge hefty rents to their bosses, boards and shareholders, each of whom, as you journey up the organizational chart, understand less about the complex services, and like clients, are then less able to defend their own interests.
Some of the best evidence forming the intellectual underpinning of this is provided by economists Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, whose work found that about 30 to 50 percent of the extra pay bankers get as compared to similar professionals is attributable to rents. <http://people.virginia.edu/~ar7kf/paper s/pr_rev15_submitted.pdf>
In theory, these rents should have only increased after government support and while banks benefit from an implied guarantee applied selectively to the too-big or too-interconnected to fail. Allowing Lehman to die but then effectively ruling out the death of Citigroup, Goldman Sachs or Bank of America does little to foster more perfect competition.
A look at profits and bonus payments on Wall Street gives ample support to this view.
WHEN THE DEVIL MEETS THE DETAILS
The FAT tax proposal lays out a number of ways it could be structured, but does beg some important details. In essence the FAT would be a tax on profits and remuneration in financial services. If the base being taxed only included high levels of remuneration — think big bonuses and salary — and only profits above a reasonable base, allowing for a good return of capital but nothing huge, then it would approximate a tax on rents, according to the IMF.
Of course, deciding what constitutes a reasonable return on capital or high compensation will not be easy.
Taxing profits over a particular level will also tend to reduce excessive risk-taking by employees. Why swing for the fences with risky deals if the bank will give up more of the extra profits?
We can also hope that the two taxes will tend to reduce the size of the financial sector, which given the stunning lack of evidence for it adding value in proportion to risk and suffering, is a good in itself.
One real concern is that, even if such taxes aren’t passed on to clients, they may, by shrinking the financial sector, have an unpleasant effect on asset prices and, by extension, economic activity. That is probably true, but asset prices are going to have to fall in real terms in one way or another, either uncontrollably via rampant inflation when the bills for the next crisis come due, or slowly and grindingly as balance sheets and the financial sector shrink.
Already the costs of the current crisis have been huge, and in themselves serve as a justification for taxes to control and shrink the financial sector. Even including all of the paybacks that get so much attention, the fiscal costs of direct support of banks averaged 2.7 percent of gross domestic product for G20 large, industrialized nations.
The amounts pledged — things like guarantees — equaled 25 percent of GDP during the depth of the crisis. And for those foolish enough to argue that the reflation worked because Goldman Sachs et al have repaid their loans, the true cost, as cited by the IMF, is a lot closer to the 40 percent rise in government debt in G20 countries between 2008 and 2015.
These taxes are sure to face huge opposition, especially in the United States, and may never come to be, but stranger things have happened, especially recently, and it is worth a try.
(Editing by James Dalgleish)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)