A Growing Concern: Bank Taxers Without Borders

A global bank tax would be bad no matter how you slice it

British Prime Minister Gordon Brown announced last month that he will propose a “global bank tax” at the G20 meeting in June. It is still unclear what kind of tax this will be, but in any event we can expect it to be counterproductive to any real recovery for the global economy and for curing any ills within the financial sector.

If the tax is a one-off “fine” for the whole banking sector, a bank levy similar to the one proposed in the U.S., this would be tantamount to punishing all banks, whether or not they actually engaged in imprudent investment activities. Also, since the worst performers have been bailed out by various governments, the net effect of the tax and bailouts would be a cross-subsidy, whereby prudent banks are forced to pay off imprudent banks, thereby creating yet another layer of perverse incentives for the banking sector.

If the tax is an involuntary payment into some kind of bank insurance scheme, something which the IMF is opposed to, this would create the impression that the government is committed to rescue any bank from its own financial follies, which would create even more moral hazard for the banking sector. Former implicit bailout guarantees of too-big-to-fail institutions would now effectively become explicit guarantees to all banks paying the tax, further removing incentives to act prudently. In the words of British economist John Kay: “More likely, by institutionalizing the concept of ‘too big to fail’, the scheme would aggravate the underlying problem of moral hazard. It would also transform state funding of the banking system from an exceptional response to a dire emergency into an expectation, even an entitlement.”

Furthermore, if this is a flat tax, banks would not get any of the benefits of traditional insurance, since prudent and imprudent banks would be taxed alike, thereby avoiding all risk premiums. This creates the perfect scheme for making banks place risky bets, as all profits are private, whereas any large-scale losses would be socialized.

So far the British government has been overly generous in its aid to the country’s troubled financial sector. According to estimates by the National Audit Office, the total value of subsidies, injections and guarantees extended to the UK financial services industry amount to the staggering sum of 1 trillion pounds or approximately 1.6 trillion U.S. dollars, which is more than double the size of the American TARP program passed by Congress in 2008 to help the ailing U.S. financial sector.

Even though no one yet knows the final price tag for the manifold bailout efforts in the industrial countries afflicted by the financial crisis, if we were to add up these costs we would surely find that the money needed to insure the global financial system against a similar incident would be immense. John Kay points out that a fund financed by the tax would not even come close to such figures, and in the event of another financial crisis, once more the burden will have to be shouldered by taxpayers. So the only effect of the scheme would be to encourage risky behavior, at the same time keeping taxpayers on the hook for the costs of future financial failures.

There are more troubling aspects to the “global bank tax.” Since the tax, if passed, would only cover the G20 countries, this would create strong incentives for banks to move their activities out of these countries and into less transparent jurisdictions, such as Switzerland. Already last year, when Gordon Brown was proposing a 50 percent top rate of income tax for high-earning bankers, some Swiss cantons launched a marketing campaign, targeting British financial firms, to get them to move their companies to Switzerland.

In other words, such a tax would mean that the British government puts its own financial firms at a disadvantage, compared to non G20 banks, encouraging them to move abroad. The financial services industry is of crucial significance to the British economy. The City of London ranks as the world’s most important international financial centre, and the services provided were the largest exporting item for the UK in the 2000s. Banking has been the single largest contributor to UK exports (net exports totaling £12.2 billion), followed by insurance ( 3.5 billion) and securities dealing (£3 billion), in 2006.

From 2001 to 2006 the sector’s share of GDP rose from 5.5 to 9.4 percent. The financial sector has been the major contributor to GDP and employment growth. Obviously, there is some need to scale down this sector, as the unsustainable financial boom preceding the crisis led to a bloated financial services industry, to a certain degree tying up resources that would be more productive elsewhere in the economy. However, by imposing this tax, the British government would only hurt its own economy, making a sustained economic recovery even harder.

The proposal also comes at a time when the U.K. government faces the urgent need to start cutting the budget deficit. This will be painful, as it will entail both spending cuts and tax increases. By proposing a bank tax, the British Prime Minister creates the impression that the financial sector could shoulder a large part of the needed tax increases. However, the most likely scenario would be for banks and other financial firms to find ways around this tax, such as moving abroad. If this happens, the British tax base would actually shrink, making the British fiscal position even weaker.

A new tax to punish the banking sector would create more uncertainty, not unlike the U.S. proposed “Volcker Rule.” This comes at a time when what is most urgently needed is a return to some kind of normalcy that will allow businesses to conduct long-term planning. Constant attacks on the banking sector by European leaders and the Obama administration is hardly conducive to stabilizing the financial services industry or contributing to sustained recovery for the rest of the economy.

Finally, if the G20 proposal turns out to be a Tobin tax, i.e. a tax on international currency movements, as was suggested by Gordon Brown last year, this would make international capital flows less efficient and to some degree discourage capital from floating into the countries that need it the most – the developing world. Such a tax would not do anything to stop money from flowing out if a crisis hit, though, because the potential losses to investors of keeping the money in the crisis-ridden country would be so much higher than the tax.

Using the proceeds of such a tax to combat climate change, as French President Nicolas Sarkozy and Gordon Brown have suggested, is simply preposterous, as the financial services industry in no sensible way contributes to global warming.

The prospects of a Tobin tax are slim, though, as the U.S., Canada and Russia rejected the idea when it was proposed at the last G20 meeting in November 2009. And the Director of the International Monetary Fund, Dominic Strauss-Kahn, himself usually sympathetic to the idea of government regulations and intervention, showed little enthusiasm, calling the proposal “a very old idea that is not really possible today.”

Even Gordon Brown himself has previously referred to the tax as “having very substantial drawbacks,” before changing his mind at the last G20 meeting. While Chancellor of the Exchequer, in 2002, he also made the quite obvious point that “it is very difficult to advocate a tax, that has been, in a sense, rejected by the person who put the proposal forward,” referring to how economist James Tobin himself came to the conclusion that such a tax would be a bad idea.

There is nothing to suggest that a Tobin tax would have prevented the current financial crisis. There is nothing to suggest that any of the other taxes outlined above would have hindered the global meltdown. And there is little reason to believe that such a tax would improve the performance of the banking industry or in any way would reduce systemic risk. Quite the contrary: If the tax is perceived as a payment into a global insurance scheme, systemic risk will most likely be amplified.

Like Obama’s verbal attacks on Wall Street and the recently proposed “Volcker Rule,” this latest attack on bankers by the British government comes at a time when the administration is politically exhausted and in desperate need of rattling up public support. The next British general election is due to take place in May, and Gordon Brown is looking at the almost certain prospect of a solid defeat. This is one reason why we should not expect a “global bank tax” to come to fruition, as the British Conservative Party, the Tories, are less likely to propose such a tax at the June G20 meeting, once they think through the consequences this would have for the British financial sector.

Another obvious reason why we should not expect a global “bank levy” anytime soon, is that it seems unlikely that all G20 countries would ever agree upon such a tax. Some countries would outright reject it, as happened to the Tobin tax proposal, and others would come to the realization that by imposing such a tax on their own financial sectors, many financial firms would simply move out of the G20.

Last year, Brown said that “global taxes will not be introduced unless all global financial centres are able to come behind them. But I believe there’s growing support for that. We’re trying to make a global supervisory system that makes sense for all the financial centres in the world.” Such grandiose schemes seem so far to be more rhetoric than reality, and getting “all financial centers” on board, will most likely turn out to be a difficult task.