Inventing new taxes on banks is the latest political pastime in Europe and the US. A two-basis-point Tobin tax on trading, a 15-basis-point financial responsibility tax on covered liabilities, a 50% bonus tax on bankers - it all looks like a just and painless way to raise much needed revenue and to tamp down public bailout rage.
No doubt, there are good reasons for looking to the sector that precipitated much of the economic calamity for funds to repair the damage. Discouraging future reckless behaviour is the best of them.
But if we don't begin thinking much more holistically about the effects of bank taxes on bank behaviour, we will simply wind up pushing risk in other undesirable directions. Indeed, the recent crisis owes at least partly to bad incentives provided by the tax code.
A June 2009 cross-country International Monetary Fund study concluded that "the empirical evidence suggests that tax distortions have caused leverage to be substantially higher than it would have been under a neutral tax system", that "taxation significantly affects [corporate] financial structure" and that "corporate-level tax biases favouring debt finance, including in the financial sector, are pervasive, often large - and hard to justify given the potential impact on financial stability".
According to an October 2005 Congressional Budget Office study, owing to interest tax deductibility and accelerated depreciation for debt-financed investments US corporations face an astounding 42-percentage-point effective tax rate penalty for equity-financed investments (36%) vis-ŗ-vis debt-financed investments (-6%). This naturally encourages them to operate at elevated levels of leverage, and made them financially vulnerable as borrowing costs soared during the crisis.
Financial institutions, of course, have been the worst affected. The IMF study noted that "the high profitability of financial institutions in recent years will have made debt more attractive for them than for many non-financials" and that the development and use of many complex financial instruments "is, in part, a response to, and shaped by, underlying tax distortions".
The Modigliani-Miller theorem, otherwise known as the capital structure irrelevance principle, demonstrates that the proportion of debt and equity capital a company uses to finance itself is immaterial - the cost is the same - in the absence of policy distortions that affect the cost of each.
If Modigliani-Miller held in reality, banks would be indifferent to the composition of capital requirements. Instead, the mere suggestion that equity capital should be bolstered evokes apoplexy among bank senior management. Securitisation and the originate-to-distribute business model are encouraged by the tax code, as loans added to a bank's books necessitate more tax-disadvantaged equity.
Both the US Federal Reserve and the US Treasury have made revival of the securitisation markets a top priority, but neither has questioned whether fiscal policy made parts of the economic system more vulnerable by encouraging excessive levels of securitisation.
Consider just one specific product that featured in the securitisation boom and the subsequent crisis: collateralised debt obligations, whose values and payment streams are derived from an underlying portfolio of fixed-income securities. Sliced into tranches according to credit ratings, these complex securities have, since the crisis broke, been popularly painted as an exercise in bamboozling investors.
In fact, they were primarily an exercise in tax arbitrage. CDO owners typically entered into credit default swaps with sellers who, because they were required to mark their positions to market, received more tax offsets on losses than did the CDO owners. And the riskier CDO tranches generated proportionally more tax advantage.
The broad effect is that the repackaging of debt into risk-tiered tradable derivatives allowed financial institutions to reallocate capital income flows based on the tax attributes of the parties. The net result for the economy is a less efficient allocation of risk driven by tax considerations.
It should not be surprising that the sector of the economy that makes its money from managing money should be the most sensitive to changes in its cost. Yet President Barack Obama's administration appeared surprised to learn that its proposed 15-basis-point financial responsibility tax was three times the normal spread in the $3.8 trillion repo market, and would therefore result in its obliteration.
Tobin-taxing congressmen also appear unaware that a two-basis-point trading levy is over 400 times the Eurodollar-futures transaction fee at the Chicago Mercantile Exchange. How this jibes with the political consensus that trading needs to be pushed onto regulated exchanges is therefore never discussed. These are clear indications that not enough thought is being given to the design of new taxes - let alone reform of the old ones.
What is critically needed is a strategy that aligns tax policy with regulatory reform goals, rather than putting the two at odds.
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.