IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
The Obama administration has just proposed a new fee — otherwise known as a tax — on the country’s largest financial institutions. The tax aims to recover the difference between the bailout funds provided to these institutions a year and a half ago and the amounts ultimately returned to the Treasury. In so doing, the tax will allegedly reduce the federal deficit by some $90 billion.
This tax has popular appeal because the bailed-out financial institutions are now earning large profits and appear ready to announce huge bonuses for their executives. Given an unemployment rate of 10%, populist demand to punish bankers and financiers is almost inevitable. Yet the proposed tax is misguided at every level. The tax will not fall solely or even mainly on its desired political target, the shareholders and highly paid executives of large financial firms. The true burden of a tax often lands far from its intended target as the target attempts to shift the burden. In this case, higher taxes mean higher costs and therefore higher prices, so customers (borrowers) will bear some of the burden of the tax. Higher costs (along with limits on compensation) will also induce financial firms to shift their operations overseas, where taxation and regulation are often more benign. Thus the tax will impose little harm on those that the populist outrage seeks to punish. Instead, the tax will hurt borrowers — an odd move from an administration concerned about a credit crunch — along with the employees of these firms, from middle management to secretaries and janitors. The proposed tax will also raise less revenue than promised, again because those subject to the tax will take steps to avoid it. Relocation overseas is one approach; accounting gimmickry is another. The net revenue raised may even be negative because the U.S. will not collect income or payroll taxes from those thrown out of work by an exodus of financial institutions. The new tax will thus fail to promote its stated goals. Worse, it distracts attention from the real issue. The U.S. made a huge mistake in bailing out the financial industry. Bankruptcy would have been the right way to punish the financial sector for its excesses. High profits and large bonuses are perfectly fine — they are the reward for risk-taking — but only if those reaping the rewards in good times actually pay the piper in bad times. Absent the bailout, many financial institutions would have failed or suffered serious losses, driving down profits and bonuses. This is the way capitalism is supposed to work. The bailout short-circuited this process, protecting the financial sector from much of the risk it assumed in the pursuit of high profits. Advocates believe the bailout was necessary to prevent a financial meltdown, but even if they are right — which is highly debatable — the bailout let Wall Street off the hook. And by rewarding excessive risk-taking, the bailout planted the seeds of the next crisis. The Obama administration did not institute the bailout, but Sen. Obama voted for it, and President Obama appointed one key architect, Timothy Geithner, as Treasury Secretary and has nominated another, Ben Bernanke, for a second term as Fed Chairman. More broadly, the administration has not criticized the bailout as misguided, but instead characterized it as necessary to save the financial system. Yet despite the bailout and the $780 billion fiscal stimulus, which the administration signed in February, the economy still languishes. This is the real reason for the tax on financial firms: a desire to scapegoat the banks and shift attention from growing concern that neither the bailout nor the stimulus has resuscitated the economy. Two wrongs do not make a right. The bailout is a done deal, so the goal for the government now must be to end all special treatment of the financial industry, favorable or punitive. Policy must focus on providing a stable environment that rewards success rather than punishing it. The proposed tax impedes these objectives because it responds to a political need rather than reflecting a rational analysis of the costs and benefits of government policies. If America continues on this path, the end point will be crony capitalism in which the politically connected thrive while almost everyone else suffers. It is not too late to turn back. Rejecting the bank tax is a good first step.