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IMF bank tax proposals: A summary

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21st Apr 2010
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The Oxford University Centre for Business Taxation has released a detailed summary of the two new proposed bank taxes.

Under the new proposals, all institutions would pay a financial stability contribution (FSC) - which would initially be levied on a flat rate, but would be adjusted over time to reflect the risk at each institution – as well as a new financial activities tax (dubbed the 'FAT' tax) on profits and pay.

According to the report, the 'FAT' tax could be considered as an alternative to VAT (which is not currently chargeable in the banking sector and could work to shrink the financial sector in line with the rest of the economy.
It also warns that the FSC could encourage greater risk taking in the sector by offering an insurance against riskier transactions.

Both taxes would be considerably more effective if applied in a coordinated way by the G20 countries, suggests the authors, Professor Michael Devereux, Clemens Fuest and Giorgia Maddini of the Oxford University Centre for Business Taxation.

Below is a a breakdown of some of the key observations on each tax.

Financial activities tax (FAT)

  • The “Financial Activities Tax” (FAT) is a combination of a tax on excess profits and a tax on remuneration. Combined, this amounts to a tax on value added. Since financial services are not typically subject to VAT (because identifying value added through the normal VAT invoice-credit method is technically difficult), the FAT could be seen as an alternative to the VAT.
  • To the extent that the financial sector has grown too large due to the absence of VAT, then the FAT would tend to reduce the size of the sector relative to the rest of the economy.
  • Combining both components of the FAT implies that the tax liability does not depend on whether gross profits are paid out to employees in bonuses or other remuneration or accrue to shareholders.
  • The excess profits component would raise revenue without affecting banks’ behaviour, since it is targeted at what banks aim to maximize. However, the remuneration component will create an additional tax wedge on employment costs. As with a normal VAT, the tax may be passed on in higher prices to customers.
  • The tax would not affect the risk-taking activities of banks. Control of banks’ risky activities would be left with the regulatory system, although it would also be affected by the Financial Stability Contribution, described below. 

Financial stability contribution (FSC)

  • The idea of the FSC is to levy a charge on financial companies to contribute to building up a fund to pay for financial support in the event of another financial crisis. The charge is therefore intended to be similar to an insurance premium: riskier companies should pay more tax. The measure of risk proposed is the proportion of the company’s assets funded by uninsured liabilities.
  • By providing explicit insurance, the FSC raises significant problems of moral hazard. If bank managers, owners, or creditors believe that they are insured against future failure due to excessive risk-taking, then they are more likely to undertake riskier behaviour. That would exacerbate the likelihood of a future financial crisis.
  • On the other hand, if banks believe that they are already implicitly insured (that they will anyway be bailed out in the event of a crisis), then the problem of moral hazard exists anyway. In this case, governments may as well introduce a tax as a form of insurance premium, to cover any future bailout costs.
  • Paradoxically, even apart from the moral hazard problem, the FSC could exacerbate risk-taking. A levy on non-insured liabilities may increase the incentives for banks to hold more equity capital. But regulatory capital requirements typically depend on the risk of a bank’s asset position. A tax that induced banks to hold more equity capital would relax this constraint, and could therefore permit banks to hold riskier assets. The tax would effectively distort risk-taking patterns without necessarily reducing the amount of risk taken by banks. In addition, it would increase the cost of using financial intermediation and may thus slow down economic recovery.

 

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