January 14, 2010
The Bank Tax: Win/Win/Win/Win=Lose?
Posted by Erik Gerding

Christine continues to stir the pot with her incisive questions on the new proposed tax on bank (and other financial firm) risk-taking. Let me add a little more spice.

As Christine notes, politically, this tax seems like a win/win/win/win solution. It targets firms seen as responsible for the financial crisis, it supposedly soaks firms giving out bonuses, it cuts down on bank risk-taking, and it raises revenue to pay for the bailout. How could four wins possibly equal a loss?

Because Satan is always in the details. Here are some more questions to ask:

1. Tangled up in Taxes: I found the part of the President’s speech calling on banks to call off their accountants and lawyers from gaming the tax amusing. Our tax colleagues are going to have a field day with that comment. So will accountants (I am anxious to read Larry Cunningham’s further takes on this.

Tax law in the U.S. seems congenitally programmed towards adversarialism and complexity. Perhaps this tax will be different.

2. Taxes versus traditional banking law tools: My gut feeling tells me that if we are interested in regulating risk, then we should work traditional banking tools, like capital requirements, loan-to-value ratios etc. I asked earlier, how this tax would fit with traditional banking tools, such as capital requirements. Would it supplant them?

Going back to point 1, capital requirements have several advantages over taxes. Although banks certainly have incentives to game capital requirements, the incentives are likely weaker than to game taxes since capital remains the bank’s own money.

In terms of administrative posture, here is a question for Christine and David: do you think that bank regulators have a better tool kit to regulate bank risk-taking because the regulatory process (rule-making and inspections) is less like litigation than tax?

The problem with traditional bank tools, as Christine pointed out, is that they are neither politically sexy nor do they raise revenue. In other words – we only get one of the four wins mentioned at the beginning of the post.

3. Scalpels and sledgehammers: It might be better to go after each of these four “wins” – revenue, risk-taking, executive compensation, punishment – with separate tools, so we can accomplish their objectives in a more economically and legally principled fashion. It’s better to use four scalpels then one sledgehammer.

4. Bonuses and Zombies: As an example of how this win/win/win/win tax may not do what it sets out to do, consider the President’s statement that banks can’t complain that this tax will hurt the recovery when they are paying out bonuses. Two problems with that. First, dollars to donuts, banks will pay out bonuses regardless. Second, the tax doesn’t target only banks that pay bonuses; it focuses on the size of bank liabilities.

What happens to banks that are not paying out bonuses, but have large liabilities? Not every firm is in Goldman’s enviable financial situation. I worry that we are going to further un-level the playing field among financial firms between the currently strong and the currently weak, and raise the risk of zombifying sicker firms.

These are questions: I’m not dismissing this tax out of hand, but this needs a lot more thought. And of course I realize objections to the tax will be used by parties with all sorts of nefarious interests. But my interests are what is good policy, not who will score.

A more inchoate concern: I worry that this distracts from other regulatory reform pieces. The Obama Administration has a lot of good reform ideas (of course kinks need to be worked out). The waves from this ocean liner entering the harbor may push some of those smaller, nimbler boats out to sea.

Here is a more bottom line concern: is this the wrong moment in the recovery to impose a tax not based on profits but on risk-taking?  We do have a history in the U.S. of recoveries from crises being short-circuited by political demands.  The President spoke about escaping the boom and bust cycle.  I've been interested in and writing about financial cycles -- so that's music to my ears.  But, if we are going to make taxes countercylical - you raise the tax in boom years and lower it in bust years.  Not an easy thing to time.  It's also not easy to create the political discipline to raise and lower taxes at the right moment.

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