The President's Bank Tax Rests on Shaky Foundation

Though President Obama's proposed bank tax might seem like a good way to reduce risk-taking among larger financial institutions, the tax would cause numerous unintended consequences. Rather, other policy alternatives can more effectively offer sustainable solutions in which banks make prudent decisions without having to raise fees or decrease services.

At first glance, the bank tax in President Obama's proposed budget might seem like a good idea. The proposal would tax the liabilities of financial firms with at least $50 billion in assets. These firms would pay a fee of 7 basis points, meaning that a firm with $100 billion in liabilities would pay $70 million each year.

The thinking behind the tax is logical. Subsidies and taxes tend to affect peoples' risk-taking behavior. Therefore if you want to make bankers take less risk, you might try taxing their liabilities.

But there are several major problems with the proposed tax. First, the tax presumes that the size of a financial firm alone constitutes a problem. But I maintain that we need banks of all sizes in a competitive financial system. Some people prefer to deal with bigger banks over smaller banks, and bigger banks may experience economies of volume.

Moreover, politicians and lawyers may not have the final say on who bears the cost of a tax on firm size. A tax on financial firms managing $50 billion or more in assets may simply translate into more fees or less services for customers.

The narrative in the president's budget isn't right either. It suggests that we need a tax to stop financial firms from taking on more risk. And the passage referring to the tax, on page 55 of the budget, also suggests that the "too big to fail" problem has been solved.

That ignores a widely held, nonpartisan belief in Washington, academic and banking-policy circles worldwide that TBTF remains an issue. For instance, the Senate Banking Committee has held a number of hearings to address the perceived TBTF problem caused by banks like Citibank.

Assuming the issue persists, Minneapolis Federal Reserve Bank President Narayana Kocherlakota suggested a better tax several years ago. Kocherlakota says that because a financial firm's debts might be guaranteed by the government after a crisis, the risk that a firm creates should be treated as a form of "financial pollution." Therefore the firm should be taxed by an amount that exactly offsets the cost to society.

Since Kocherlakota believes that regulators could neither effectively measure nor monitor that risk, he offers a market alternative. He suggests that the government issue "rescue" bonds to investors for each financial firm. The bonds would pay investors only in the event of the firm's insolvency.

This means that the financial firms would be taxed by an amount that increases with the value of the bonds, which would rise as the likelihood of that firm's failure increases. Both the rescue bonds and tax would be used to make a financial firm pay for any future damage it might cause to the financial system. By contrast, the tax in the proposed budget appears to be a mechanism to cover the cost of past actions, much like the Department of the Treasury's Troubled Asset Relief Program.

An alternative to taxing financial firms also exists: higher capital requirements. Capital, held in the form of long-term debt and equity measured at market value, can eliminate incentives for financial firms to take on the risks we observed prior to the crisis.