Hefty bank taxes sound nice, but are they the solution?

One option the government should consider is imposing a taxes on each bank equal to the government’s future cost of bailing it out. The more risky a bank's investments, the higher the taxes.

Frank Polich/Reuters
Union members march past the Federal Reserve Bank in the financial district of Chicago, to protest the government's bailout of banks on April 28. Taxing banks to compensate for their recent bailout seems reasonable. But how?

Washington is buzzing with talk about taxing banks. And after watching the Goldman Sachs masters of the universe testify on Capitol Hill a couple of weeks ago, it is no surprise that many want to tax these people until they bleed.

Unfortunately, punitive taxes are a bad idea, no matter how good they make us feel. But could a well-designed levy drive financial firms to allocate capital more efficiently? Maybe so, says Narayana Kocherlakota, the new president of the Federal Reserve Bank of Minneapolis.

Unlike some, Kocherlakota does not want to tax bigness. Nor does he want to tax specific activities such as perverse executive compensation that rewards short-term speculation or portfolios that hold “too many” derivatives. Instead, he wants to tax risk.

In a May 10th speech to the Economic Club of Minnesota, the Fed president compares financial institution risk to pollution. While I love this image, it doesn’t quite mean what you might think. To an economist, the pollution created by a factory is an externality. That is, its cost is borne by society at large, and not by the polluter’s shareholders or customers. The trick to getting a company to stop spewing waste is to make the firm pay the social cost of its own pollution.

It is the same, Kocherlakota says, with financial institutions. He starts with an assumption that government will always bail out the big, stupid, and greedy in the midst of a financial crisis. “Policymakers,” he says, “inevitably resort to bailouts even when they have explicitly resolved, in the strongest possible terms, to let firms fail.”

Depositors and investors know this and, as a result, are willing to accept lower interest rates on the loans they make to these too-big-to-fail institutions. This relatively cheap money, in turn, encourages the banks to take on more risk and more leverage.

So what to do? Kocherlakota says the government should impose a tax on each bank equal to the government’s future cost of bailing it out. Banks that make very risky investments would pay higher taxes. Those that make less risky investments would pay lower taxes.

It is an elegant solution. But it has one big problem. While we do a pretty good job of measuring pollution, we are really bad at figuring the value of future bailouts. As Kocherlakota says, with some understatement, “These calculations are likely to be complex in a number of ways [and] could well be controversial.”

He’d use the market itself to help measure this risk. The government would issue a security—a rescue bond--for each financial institution. The price of the bond would rise or fall with the market’s perception of the firm’s risk, and the tax would be tied to the price of the bond. Of course, the recent financial meltdown was caused in part by the market’s inability to calculate the risk that firms such as Lehman Brothers and AIG would fail. If this tax is to succeed, investors would have to know a lot more than they do today about what securities are sitting in a bank’s portfolio.

A different bank tax has been endorsed by the Obama Administration. The House financial regulation bill includes a version as well, although the Senate’s does not. A skeptical Finance Committee held another in a series of hearings on the subject today. I’m not sure whether Kocherlakota’s provocative idea can work in the real world, but it is worth thinking about.

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