Hefty bank taxes sound nice, but are they the solution?
One option the government should consider is imposing a taxes on each bank equal to the government鈥檚 future cost of bailing it out. The more risky a bank's investments, the higher the taxes.
Union members march past the Federal Reserve Bank in the financial district of Chicago, to protest the government's bailout of banks on April 28. Taxing banks to compensate for their recent bailout seems reasonable. But how?
Frank Polich/Reuters
Washington is buzzing with talk about taxing banks. And after watching the Goldman Sachs masters of the universe on Capitol Hill a couple of weeks ago, it is no surprise that many want to tax these people until they bleed.
Unfortunately, punitive taxes are a bad idea, no matter how good they make us feel. But could a well-designed levy drive financial firms to allocate capital more efficiently? Maybe so, says Narayana Kocherlakota, the new president of the Federal Reserve Bank of Minneapolis.
Unlike some, Kocherlakota does not want to tax bigness. Nor does he want to tax specific activities such as perverse executive compensation that rewards short-term speculation or portfolios that hold 鈥渢oo many鈥� derivatives. Instead, he wants to tax risk.
In a May 10th to the Economic Club of Minnesota, the Fed president compares financial institution risk to pollution. While I love this image, it doesn鈥檛 quite mean what you might think. To an economist, the pollution created by a factory is an externality. That is, its cost is borne by society at large, and not by the polluter鈥檚 shareholders or customers. The trick to getting a company to stop spewing waste is to make the firm pay the social cost of its own pollution.
It is the same, Kocherlakota says, with financial institutions. He starts with an assumption that government will always bail out the big, stupid, and greedy in the midst of a financial crisis. 鈥淧olicymakers,鈥� he says, 鈥渋nevitably resort to bailouts even when they have explicitly resolved, in the strongest possible terms, to let firms fail.鈥�
Depositors and investors know this and, as a result, are willing to accept lower interest rates on the loans they make to these too-big-to-fail institutions. This relatively cheap money, in turn, encourages the banks to take on more risk and more leverage.
So what to do? Kocherlakota says the government should impose a tax on each bank equal to the government鈥檚 future cost of bailing it out. Banks that make very risky investments would pay higher taxes. Those that make less risky investments would pay lower taxes.
It is an elegant solution. But it has one big problem. While we do a pretty good job of measuring pollution, we are really bad at figuring the value of future bailouts. As Kocherlakota says, with some understatement, 鈥淭hese calculations are likely to be complex in a number of ways [and] could well be controversial.鈥�
He鈥檇 use the market itself to help measure this risk. The government would issue a security鈥攁 rescue bond--for each financial institution. The price of the bond would rise or fall with the market鈥檚 perception of the firm鈥檚 risk, and the tax would be tied to the price of the bond. Of course, the recent financial meltdown was caused in part by the market鈥檚 inability to calculate the risk that firms such as Lehman Brothers and AIG would fail. If this tax is to succeed, investors would have to know a lot more than they do today about what securities are sitting in a bank鈥檚 portfolio.
A different bank tax has been endorsed by the Obama Administration. The House financial regulation bill includes a version as well, although the Senate鈥檚 does not. A skeptical Finance Committee held another in a series of on the subject today. I鈥檓 not sure whether Kocherlakota鈥檚 provocative idea can work in the real world, but it is worth thinking about.