Fiscal policy and the worldwide economic and financial crisis ( 391,25 KB )

 

  The financial crisis of 2007 led to the worst economic recession since the Great Depression. The nature of its trigger (the subprime crisis in the United States), the losses recorded by financial institutions around the globe and the contribution of public funds to sort it all out have resulted in an overall revaluation of the mechanisms to safeguard the stability of financial markets. Although the priority has been to set up suitable regulations and supervision, some wonder whether to complement this strategy with a new fiscal policy for the sector. The objective would be twofold: to correct negative externalities attributed to certain activities and to garner additional funds given the necessary consolidation of public accounts after the crisis. But is there any taxation formula that can achieve this dual bonus without creating new distortions? Is it viable or would it require too much sacrifice in terms of efficiency or implementation costs?

  Several countries are considering changes of this type or weighing up the arguments for greater financial taxation. Their defence is based on two points: collecting revenue from the financial sector to meet the cost of future restructuring and to complement the regulations that aim to reduce systemic risk. Although the revenue argument is more or less supported depending on the forum (many central governments already get substantial revenue from the sector via company tax, while the public cost of the recent bail-out was very different depending on each country - see the graph below), after the Lehman bankruptcy few question the idea that certain financial activities involve negative externalities for the rest of the economy.

  The IMF estimates that the implicit public guarantee enjoyed by institutions that are «too big to fail» reduces the cost of their funding by around 20 basis points and encourages them to finance excessively risky investment without taking into account the external cost entailed. These externalities include the cost of bailing them out should the operation go wrong and the less than optimal channelling of resources towards activities that fail to maximize the welfare of society.(1) The volatility introduced into the system by short-term and purely speculative movements, normally associated with derivatives and hedge funds, is also brandished in favour of a review of financial fiscal policy that doesn't prioritize revenue so much as the internalization of external costs and a reduction in systemic risk. Those who are against this do not question the argument's validity but the appropriateness of using taxation as a solution rather than changing the dual regulation-supervision system.

  The alternatives under debate are currently limited to three: a Financial Stability Contribution (FSC), a Financial Activity Tax (FAT) and a Financial Transaction Tax (FTT) in the Tobin style.(2) At the G-20, the International Monetary Fund proposed the creation of a new two-level fiscal system including an FSC and an FAT, applicable to all kinds of financial institutions.(3) The tax rate for the FSC could be calibrated according to the systemic risk of each institution, its taxable base resulting from the external funding of financial institutions (excluding deposits, guaranteed reserves and Tier 1 capital) and its revenue being used to finance part of the direct cost of future restructuring. On paper, an FSC applied sufficiently widely could avoid distortion in financing decisions (such as excessive leveraging). In practice, its viability is compromised by the complexity and difficulty in defining a suitable tax rate that accurately reflects each institution's contribution to the aggregate risk.

  Unlike the FSC, the taxable base for the FAT is not obtained from the balance sheet but from the profit and loss account; it would be taken from returns and profits of financial institutions, with the opportunity to choose between taxing these as a whole, this thereby becoming a pseudo value added tax, or taxing only «excessive» income, based on the idea that this comes from unjustified risk and the implicit guarantee of the central government. A well-designed FAT could align incentives to minimize unwelcome risk-taking but the viability of this kind of tax arouses even more controversy than the FSC. The IMF itself stresses that the effectiveness of this tax hangs on international coordination; if there is none, tax evasion by changing country and dual taxation might cancel out its effect or even make it counter-productive. Neither is it clear how to determine which level of income is excessive for the financial sector without ending up taxing gains that may actually come from greater effort or efficiency and not from greater risk.

  Unlike the rest of the alternatives, the FTT is not a tax on the financial sector per se but on financial markets. Applied generally, its taxable base would include any financial transaction carried out in markets, whether these are organized or not (over the counter); in its limited version, it would only tax bonds and shares in organized markets. The tax rate would be relatively low as it would be applied each time the asset in question was traded.

  Those who support this kind of tax claim that an FTT with a wide base would help to substantially reduce the volatility of financial markets. However, this premise has been called into doubt by empirical evidence and, moreover, involves serious implementation problems: defining the taxable base in derivative transactions is highly complex; the risk of moving to external jurisdictions is even greater than in the case of the FAT if this is not coordinated at a G-20 level, something not very likely considering that several countries, including the United States and the United Kingdom, have already rejected it; and its revenue would be distributed unevenly, concentrated in just a few financial markets that carry out most of the transactions. Nonetheless, the main drawback is that it doesn't differentiate between «beneficial» and «harmful» transactions, so that it would end up reducing efficiency and liquidity in the system, hindering the correct channelling of resources and making it difficult to hedge risk without tackling the main problem: the misalignment of incentives.

  (1) See the Box entitled «Guaranteed bail-out: a risky perception for the system» in the April Monthly Report.

  (2) Tobin, J. (1978). «A proposal for international monetary reforms», Eastern Economic Journal, 153-159.

  (3) «A fair and substantial contribution by the financial sector. Final report for the G20», IMF (2010).

  In short, none of the proposals is without these unwelcome side effects or even possible legal interference with other measures or regulations currently in force. This explains why the ideal action has yet to be agreed, not even in terms of what should be taxed, let alone a definition of the taxable base, tax rate or scope of application.

  Given this disagreement, and given that the regulatory reforms underway already place new demands on a still fragile financial system, a parallel reform of fiscal policy demands a large dose of caution. In any case, as in the regulatory area, international coordination is vital.

  This box was prepared by Marta Noguer

  International Unit, Research Department, "la Caixa"

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