Huntsman Wants to End "Too-Big-to-Fail" with Bank Tax

December 12, 2011

Presidential candidate Jon Hunstman has recently proposed that a fee be levied on banks which are too big to fail, (a bank tax of sorts) determined by asset size.  As he puts it, "We need banks that are small and simple enough to fail, not financial public utilities." These "financial public utilities" of which he speaks are the six largest U.S. financial institutions which have assets worth approximately 66 percent of GDP, or $9.7 trillion.  With negative perceptions of these banks common among liberals and conservatives alike, Huntsman's ideas are sure to gain steam.  But the public should ask itself whether the plan would work and whether it is good for the economy or simply policy purely rooted in vengeance.

The reason for the proposal is simple enough.  Based on past governmental behavior, large institutions are banking on the fact that they will receive bailouts if times get rough in the future.  Thus, banks now have incentive to grow larger in size and develop even riskier portfolios.  After all, if the government is going to mitigate your downside, it is absolutely rational to take more risk, increasing the upside of your investments.  

The six main parts of the proposal (directly taken from Huntsman's latest version) are:

1.        Set a hard cap on bank size based on assets as a percentage of GDP.

2.        A similar cap on leverage - total borrowing - by any individual bank, relative to GDP. In some European countries, one bank can bring down the nation. Why would we want such unfair and inefficient arrangements in America?

3.        Explore reforms now being considered by the U.K. to make the unwinding of its biggest banks less risky for the broader economy.

4.        Impose a fee on banks whose size exceeds a certain percentage of GDP to cover the cost they would impose on taxpayers in a bailout, thus eliminating the implicit subsidy of their too-big-to-fail status.  The fee would incentivize the major banks to slim themselves down; failure to do so would result in increasing the fee until the banks are systemically safe.  Any fees collected would be used to reduce taxes for the broader non-financial corporate sector.

5.        Focus on establishing an FDIC insurance premium that better reflects the riskiness of banks' portfolios.

6.        Strengthen capital requirements, moving far beyond what is envisioned in the current Basel Accord. Broad economic flaws can be found in five out of the six points (such as the assumption in (5), which supposes that the FDIC can accurately peg the relative riskiness of all banks while conceding that it has failed to do so in the past).

Broad economic flaws can be found in five out of the six points (such as the assumption in (5), which supposes that the FDIC can accurately peg the relative riskiness of all banks while conceding that it has failed to do so in the past).

However, the fourth item is the most salient from a tax perspective.  It fails to meet minimum standards in terms of simplicity and logic.  First, Huntsman wants to impose a fee on banks whose size exceeds a certain percentage of GDP in order to reduce the systemic risk that any one bank imposes on the economy.  This seemingly easy-to-accomplish regulation would be necessarily complex.  Financial institutions obviously do not control GDP growth, yet would be subject to the fickle nature of the economy.  So while Huntsman would want to tax banks for negative externalities, he seems to forget that banks are at the whim of externalities created elsewhere in the economy. 

If a bank chooses to keep assets that exceed the "percentage of GDP cap" and then GDP improves quickly placing the bank under the GDP threshold, should the institution get its money back?  Who decides?  Likewise, if GDP declines enough to put a bank over the threshold, the institution would have to quickly sell assets to the market, creating a fire sale.  Magically, governmental regulation will have rendered securities underpriced, creating an environment for arbitrage—something that should happen only to a very limited extent in a free market.  Such taxation seems more grounded in vengeance rather than it is in proper economic analysis.

(For another idea on how to tax banks in order to minimize public risk, see Taxing Risk and the Optimal Regulation of Financial Institutions, Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis.)

Follow David S. Logan on Twitter @Loganomix

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