Taxing banks – the IMF proposals are the best we’ve seen

Limit taxpayer-exposure to future financial crises, raise revenue to replenish government finances, address supernormal, often grotesque, profits and bonuses.

Effective financial reform should have three objectives: 1. Limit the exposure of the taxpayer to any future financial crises, preferably by reducing the chances of one occurring; 2. Raise revenue to replenish government finances after the unprecedented state support offered to the financial system over the last two years; and 3. Address the very existence of the supernormal, often grotesque, profits and bonuses that can only be generated through uncompetitive and inefficient markets.

The G20 has just taken delivery of the IMF report titled ‘A Fair and Substantial Contribution by the Financial Sector’, which does its best to hit all three objectives. In brief, the IMF proposes:

A flat rate levy (‘financial stability contribution’) on financial institution liabilities either to fund an insurance pot to pay for future crises or to go straight into government coffers. Over time this rate can be altered to reflect ‘risk’, measured in a variety of ways (size, correlation etc), and will be payable by banks, hedge funds, insurance companies etc.

A variable tax on the sum of profits and bonuses (‘financial activities tax’ – yes, FAT – whoever thought the IMF had a sense of humour). In what circumstances this should be imposed is left open for discussion, but this does avoid the perverse effect of profits being reduced by increasing bonuses.

A ‘credible and effective resolution mechanism’ to ensure that if a bank looks like it is getting into trouble, it can be wound down without threatening overall market collapse.

The removal of the tax incentives for using debt finance over equity finance (the tax deductibility of interest) to reduce the instability-inducing incentives to use more and more leverage to fund operations.

International agreement on any taxes or financial reforms to prevent ‘tax and regulatory arbitrage’.

Financial jargon aside, these are the key messages:

1. Doing anything unilaterally, without agreement from at least the other major banking centres, would be silly. The IMF have therefore confirmed that the Tories and the Lib Dems are wrong on this matter.

2. A ‘FAT’ tax is one way to share the fruits of excessive profits. Defining the level at which profits and bonuses should become subject to ‘FAT’ is a difficult question that can really only be answered with final reference to ideology.

‘FAT’ in itself doesn’t address the underlying structural issues of an uncompetitive market, but the IMF’s desire to implement ‘managed bankruptcies’ points to smaller, simpler institutions over time, which is what is needed. In the short term, however, this approach makes sense again only with international agreement.

3. A levy on all financial institutions is sensible if it is implemented across the world and becomes unavoidable. The advantage of taxing all FIs is that banks won’t be able to move things around to hide them from the taxman. And the more institutions that pay that don’t derive their profits entirely from the common man (i.e. big investment banks, hedge funds) the less the burden will be shifted to consumers.

4. The other high profile proposal in this space – the Robin Hood Tax – would certainly raise revenue, but does little to reduce the likelihood of a future financial crisis and doesn’t do anything to address the inefficiencies of international finance.

It will take a great deal of effort to get international consensus on any proposal, so it seems a shame to only target one out of the three objectives, however popular. The advantage of the IMF proposal is that it packages a revenue generating tax with other reforms, which are harder to argue against and in conjunction represent genuine, long-term, financial reform.

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