Taking It to the Banks

By / 1.14.2010

Following a week of trial balloons about a tax on banks and bankers, President Obama today unveiled a “financial crisis responsibility fee,” to be levied against 50 of our nation’s largest banks. While the tax will not be able to seriously address the deficits that the government faces – it’s expected to raise only $90 billion over 10 years – any tax on the financial system can affect the course of our economy. The details of the proposed tax have yet to be outlined. Compared to the alternatives, this tax is a good start – but it doesn’t go far enough.

In the discussion of taxing banks and bankers, a couple of possibilities have been floated, some of which can reap short-term political points, others of which have the potential to promote progressive policies:

Bonus tax – One of the easiest – and politically most satisfying – would be a tax on excess bonuses. The British exercised this option on London bankers this past year. Bonuses in the City above a certain amount were taxed at a 50 percent rate. Banks responded by threatening to move offshore and – when that threat rang hollow – doubled the bonus pool they paid out to bankers. The end result was that the bankers whose decisions led in part to the crisis were financially unharmed, the British government raised a relative pittance in taxes, shareholders in City banks took a hit (as the bonus pools were increased at their expense), and the underlying fault lines in the British banking system remain unaddressed.

Transaction tax – The worst of the options would be a tax on transactions. As discussed before, this would merely pour sand in our financial system, breaking it and slowing economic recovery.

Excess profits tax – A more appealing option would be a tax on excess profits. A defining aspect of the financial bubble of the last decade was the fact that financial profits were 40 percent of overall corporate profits – more than double the slice financials made up of profits in the 1980s. A tax on these excess profits would rein that in. But while this could be useful, as Simon Johnson points out, it would be fairly easy to game, and end up being ineffective.

Tax on assets – A tax on bank assets above a certain amount addresses not just political sentiment that banks have made it through the crisis unscathed, but also the fact that banks are too big to fail. Encouraging banks to “right-size” themselves would make our economy safer from the systemic risk imposed by banks like Citigroup or Bank of America – which are debilitated but whose failure would be economically catastrophic.

Excess leverage tax – Taxing the leverage that financial institutions use to increase returns would allow us to avoid situations like that faced a year and a half ago when Lehman Brothers – leveraged over 30:1 – collapsed over the course of a weekend. It would make banks “safer” but would leave them still too big. In the event a bank were to fail, it would still be a systemic threat to our economy. This would be a more targeted version than an assets tax, but it would be harder to implement — definitions of leverage differ – and if not properly defined would leave hedge funds, insurance companies and other “non-bank financial institutions” untouched, leading to a crisis like that perpetuated by Long-Term Capital Management in 1998 or AIG last fall.

The taxes unveiled today are a very tentative step down the path towards an effective tax on assets. But the administration’s proposal is too broad – affected institutions could be as small as $50 billion — and too light to be effective.

If the Obama administration were strictly looking to tax the problem of an outsized and dangerous financial industry out of existence, a combination of the last two taxes — properly implemented to cover the whole financial sector when looking at leverage and focused on banks that are bigger than, say, $300 billion when looking at assets — would be the most effective. But hastily implemented, they could have unintended consequences, crippling our economy while merely pushing the problem offshore. Coordination with the EU and other G-20 countries will be vital to help with the de-leveraging of our economy.