After the Robin Hood tax
Move over, Robin Hood tax. Make way for the FAT tax and the hot money levy.
The European Unionâ€™s plan to put an impost on financial transactions, popularly known as a Robin Hood tax, is dying. Thatâ€™s a good thing. The idea was taken up by the Occupy movement as well as luminaries such as Bill Gates. But it never made economic sense. Taxing transactions wouldnâ€™t have dealt with any of the causes of the financial crisis such as too much leverage and excessive reliance on hot money. It would just have driven business offshore.
Britain has always opposed the tax, meaning it had no chance of being adopted by the EU as a whole. Now the Netherlands has come out against it, so it canâ€™t even be applied across the whole euro zone. With Germanyâ€™s finance minister saying that the â€śsmallest thinkable unitâ€ť for the tax is the euro zone, it is only a matter of time before the Robin Hood tax is buried.
EU finance ministers will discuss alternative ways of taxing finance later this week in Copenhagen. The guiding principles should be to rein in excess risk-taking and remove distortions that bias one form of economic activity over another. With these ideas in mind, there are three specific things Europe, and for that matter the rest of the world, should do.
First, countries should impose a â€śhot moneyâ€ť tax on banks. Such a levy would apply to a bankâ€™s wholesale borrowing. Ideally, short-term wholesale money should face an especially high levy: excessive reliance on such easy-come-easy-go funding was a big reason why banks from Royal Bank of Scotland to Lehman Brothers came a cropper. A hot money tax would encourage banks to raise longer-term money or attract relatively stable retail deposits. It would also mean that, if governments did have to bail out banks in future, the industry would at least have paid towards its own rescue.
So far 11 of the 27 EU countries – including Germany, Britain and France – have imposed such a levy, according to KPMG. The rest should follow suit. So should the United States, which has been toying with what the Obama administration calls a Financial Crisis Responsibility Fee. Although nothing will happen before the presidential election, a hot money tax could be one of the ways America eventually brings down its deficit.
Second, countries should remove the tax systemâ€™s bias in favour of debt. In most places, companies can deduct interest payments from profit before paying corporation tax. This encourages firms to leverage themselves up to the gills. The whole economy, not just the banking sector, is affected. But lenders are doubly exposed. Not only do they have an incentive to pile on the leverage themselves; they periodically get exposed to over-indebted customers, especially real estate developers and leveraged buyout houses.
Third, financial services should no longer be exempt from value-added tax. VAT is a consumption tax which is applied at each stage in the chain of production. Companies add VAT to what they sell other firms, but get a credit for what they purchase. This means only the final customer ultimately pays the tax. But in the EU and other jurisdictions, banks are not covered. They neither apply VAT to the services they provide customers nor get a credit on the VAT they pay on their purchases.
This anomaly causes several distortions. Final customers are undercharged for financial services, meaning they consume too much of them. Business customers, by contrast, are overcharged as there is no VAT they can reclaim on what they pay banks. Meanwhile, lenders have an incentive to perform activities in-house which would be more efficiently done by other companies – because they canâ€™t recover the VAT they pay to outsourcers.
The VAT exemption probably also loses governments money. No proper calculations have been done. But a tentative estimate for the UK puts the lost revenue at 10 billion pounds a year, according to last yearâ€™s Mirrlees Review.
Given all these problems, it might seem mad that financial services are exempt from VAT. But there is a reason. Banks donâ€™t charge fees for most of their services. Instead, they make the bulk of their income from the spread between the interest they charge for loans and what they pay depositors. Dividing up this spread among specific customers so that VAT can be applied to every bill would be quite tricky.
There are broadly speaking two solutions. One is to work through the technical complexities. The other is to introduce a financial activity tax, known as a FAT tax. This is applied to a bankâ€™s earnings and the compensation it pays employees on the theory that the sum of these is just value added by another name.
The FAT tax has potential populist appeal, not just because of its name. After all, in the current environment, who would object to taxing banker pay and bank profit? One wrinkle, though, would need to be ironed out before FAT was an ideal tax. Some way would have to be found of giving business consumers a FAT tax credit.
Thereâ€™s no disguising the fact that it would be complicated to revamp the way that banks are taxed. But given the havoc they caused in the crisis, the fact that the sector is under-taxed and the way in which the current system distorts economic activity, it is well worth the effort. The near-death of the Robin Hood tax provides a golden opportunity to do so.