Is a Bank Tax Good Tax Policy?

January 26, 2010

If it is the case, as Greg Mankiw argues in his blog, that the government cannot credibly commit to not bailout the banks should they need it again, then a moral hazard problem truly exists which in turn is encouraging banks to take excessive risk at taxpayers’ expense.

One solution to this excessive risk is for government to charge banks for what really amounts to implicit insurance that they are being provided. If you call it a tax, so be it. (There may be legal issues here, but the economics is the same regardless of the semantics.)

This tax or fee would ideally be Pigouvian in nature and be levied in accordance with the costs imposed on third parties (i.e. the taxpayers) for the implicit insurance being provided. The challenge for economists and policymakers would be to find the best proxy for that risk exposure “pollution” so as to internalize the externality and from an equity standpoint make those who are imposing the costs pay for it.

The problem of course is like any Pigouvian tax: the costs are often difficult to measure. Given this fact along with government’s propensity to make a mess of already complex situations (see tax code), what you could end up with is a piece of legislation that is not properly targeted and makes the situation worse, not better.

Addendum: Given that there are non-financial institutions that also receive implicit bailout subsidies from the federal government for various reasons (like airlines, auto companies and state/local governments), Obama should also be proposing a tax or fees on these industries as well. According to today’s CBO report, the bailout of the auto industry will end up costing (on paper) taxpayers more than the bailout of the banks. It’s just easier for politicians to attack Wall Street than the auto industry, and it helps that the party in power is largely beholden to special interests that make up the auto industry (i.e. labor unions). For more on the TARP tax, including the asymettrical treatment across industries, here’s a good summary of the issue by Luigi Zingales.


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