Wednesday, December 2, 2009

Tax incentives-based measures to tackle the financial sector overgrowth and the Too Big To Fail problems

(Click here for PDF)

Following the history-making rescue of the financial system by public funds, a near-consensus has emerged that no financial institution should be large enough to pose a systemic threat to the world economy. Most of the solutions proposed toward that objective revolve around two basic propositions: 1) break up the institutions deemed too big to fail, and 2) tighten regulations and regulatory oversight on all financial institutions so that the risk of them going belly up is reduced. There are many problems with these two propositions.

Concerning 1), how to judge fairly which institutions are too big and which are not? Concerning 2), there are already thousands of pages of regulations at the local, national and supranational level governing banking and financial activities. This, combined with the complexity of those activities and of the institutions practising them, makes the job of the regulator extremely difficult, if not impossible. The problem is not only in deciding what to do, it is also in how to implement the decisions. Moreover, financial engineering has proven time and time again that it was ahead of the regulation curve: in other words, bankers and lawyers always find a way around the rules (think of buzzwords such as SIV and off-balance sheet). For these reasons, it may be more effective to use carrots rather than sticks. Here are three possible ones:
  • To reduce the TBTF problem, a simple way is to reduce the size of the financial sector (a sector which is seldom thought to bring important and long-lasting contribution to a country’s productivity). And a simple yet quite dramatic way to reduce the size of the financial sector is to cap, or even eliminate the interest tax shield for households, non-financial corporations or financial corporations or all three of them. This would bring down the optimal leverage ratio and thus the demand for loans, which in turn would reduce the share of the economy devoted to financial activities. Although it would bring down the economy’s growth rate (although probably not in the long-run), it would also go a long way in making it more stable, as well as help reduce government deficits. Plus, why should the tax system reward borrowing in the first place? This is somewhat of a free lunch which should be eliminated.
  • Another free lunch is portfolio diversification: it brings down volatility (risk) without sacrificing the expected returns of the portfolio. However, there is a consequence, which is that once an investor believes his portfolio risk is low due to diversification, she will let individual companies’ management pursue a very risky strategy in search for high returns (for the investor) and compensation (for management). However, when every investor in every company thinks in that way, systemic risk increases – for everybody, and corporate governance can become inadequate for a large number of companies. This is what we have witnessed for large complex financial groups in recent years. For this reason, returns from very diversified portfolios should be taxed less advantageously then returns from more concentrated portfolios. Investors would then reduce the number of lines in their portfolios, which would have the effect of increasing the number of large shareholders in companies, improve corporate governance and reduce systemic risk. After all, aren’t long term gains taxed less then short term gains for the same reasons?
  • Last but not least, corporations should be taxed in the same way that individuals are in most developed countries: at a rate increasing with the absolute amount of profits. If that was the case, large banking groups would find it in the best interest of their shareholders to divest some activities as they grow in size. This would not only help tackling the TBTF problem, but also the monopoly one, and relieve the regulator from long and costly processes (remember the Microsoft case?). However, profits are very volatile, so an even more effective way to implement this measure would be to base the corporate tax on revenues (once again, just as for individuals). A third possible way would be to make to corporate tax rate proportional to the company’s market share, although this would be more complicated to implement.

These measures may seem bold, but bold is probably what we need to be if we want to avoid a repeat of the recent (and ongoing) events in the financial sector. Furthermore, they are easy to implement, could be passed unto law very quickly, would have a desirable, important and long-lasting effect on the financial sector and would not impair its ability to innovate.

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