Wednesday, December 7, 2011

The Misguided Financial Transactions Tax: Future of Banking #2

Thorstein Beck has edited an e-book for Vox on "The Future of Banking." It consists of 12 short and highly readable essays by expert economists, based on their academic research. The book is packed full of interesting and relevant analysis. This is the first of three posts on a few of the ideas that jumped out at me. The topics of the three posts are:

1) The dangers of persistently low interest rates
2) The misguidedness of a financial transactions tax
3) The rise of global banks in emerging markets

Proposals for a financial transactions tax are a hardy perennial topic. The European Commission proposed one in late September. Even the Vatican has gotten into the act by publicly supporting such a tax, a proposal I reviewed and critiqued in an October 28 post, "Financial Transactions Tax: The Vatican vs. the IMF." In this book, Thorsten Beck and Harry Huizinga offer an overview of why such proposals are misguided policy in "Taxing banks – here we go again!"

There are two main arguments for a financial transactions tax: 1) by discouraging high-frequency financial transactions, it will encourage financial stability; 2) it could raise a lot of money at a time when government budgets are stressed.

The first argument is probably incorrect. As Beck and Huizinga explain:

"As pointed out by many economists, transaction taxes are too crude an instrument to prevent market-distorting speculation. On the contrary, by reducing trading volume they can distort pricing since individual transactions will cause greater price swings and fluctuations. But above all, not every transaction is a market-distorting speculation. Speculation is not easy to identify. For example, which is the market-distorting bet – one against or for a Greek government bankruptcy? Did the losses of the banks in the US subprime sector occur due to speculation or just bad investment decisions? What is the threshold of trading volume or frequency beyond which it is speculators and not participants with legitimate needs that drive the market price for corn, euros, or Greek government bonds? Most importantly, however, FTTs are not the right instrument to reduce risk taking and fragility in the financial sector, as all transactions are taxed at the same rate, independent of their risk profile."
There is good reason to be concerned that excessive leverage can help lead to asset price bubbles and economic instability. But it is not at all clear that the raw number of financial transactions creates financial instability; indeed, it is possible that discouraging financial transactions could lead to greater instability. In this sense, a financial transactions tax is misguided.

If the goal is to raise more revenue from the financial sector, there are other ways to do it. In the European context, Beck and Huizinga point out that one simple approach would be to apply value-added taxes to financial services. They write: 

"An obvious step towards bringing about appropriate taxation of the financial sector is eliminating the current VAT [value-added tax] exemption of most financial services. The current undertaxation of the financial sector resulting from the VAT exemption is mentioned by the European Commission as a main reason to introduce additional taxation of the financial sector. However, if the problem is the current VAT exemption, isn’t the right solution to eliminate it?"

Another option for taxing the banking sector is to impose a tax on banks that have high levels of leverage. In a way, this is similar to policies where banks with low levels of capital need to pay higher premiums for their government deposit insurance--that is, it's an attempt to make banks face the possible social costs of their risky behavior. Beck and Huizinga refer to this policy as one of "bank levies":
"Bank levies are taxes on a bank’s liabilities that generally exclude deposits that are covered by deposit insurance schemes. Bank levies appropriately follow the ‘polluter-pays’ principle, as they target the banks – and their high leverage – that are heavily implicated in the recent financial crisis. Bank levies have significant potential to raise revenue and they directly discourage bank leverage, thereby reducing the chance of future bank instability. In sophisticated versions of bank levies, they are targeted at risky bank finance such as short-term wholesale finance, and they may be higher for banks with high leverage, or for banks that are systemically important."
In short, proposals for a financial transactions tax are an old nostrum. Whether the goal is enhancing financial stability or raising revenue, or both, better options are available.