If financial crises occur like clockwork every five or 10 years, as JPMorgan Chase (JPM) CEO Jamie Dimon believes, the obvious solution is to raise taxes on risky banks.
Hey, who said that — that troublemaker Paul Krugman, or perhaps another fellow traveler, like Wall Street gadfly Simon Johnson? Nope — try Federal Reserve Bank of Minnesota President Narayana Kocherlakota. In a speech yesterday, the former academic economist makes a strong case that we can limit the scale and frequency of such collapses by imposing higher taxes on financial institutions that pose a greater danger to the banking system:
[A] financial institution should be taxed for the amount of risk it creates that is borne by taxpayers. Once the firm faces the correct tax, it will choose to produce that risk with a cost-minimizing mix of capital, liquidity, incentive compensation and other factors.
Kocherlakota even comes up with an ingenious way to implement such a “risk tax.” He envisions the U.S. government issuing a so-called rescue bond, which pays a variable coupon equal to, say, 1/1,000 of the cost incurred by taxpayers to bail out a financial institution and its stakeholders. To pay for the bond, financial firms would be taxed at a rate equal to 1,000 times the price of the bond.
One reason that’s smart — the feds wouldn’t have to figure out in advance whether a financial firm is systemically risky. They could simply issue a rescue bond for every institution and allow the market to reveal the systemic importance of a company through the price of the bonds.
He also makes a helpful analogy in judging whether a bank tax would temper the kind of “externalities,” or wider social costs, caused by reckless banks. Financial institutions are no different than a company whose operations also create air pollution, Kocherlakota says. The more widgets it makes, the more pollution that must be absorbed by the local community. Trouble is, the company reaps most of the private gains of that additional production without bearing the social costs.
However, the firm will create the socially efficient level of pollution if it is required to pay for — or internalize — its full social cost. More concretely, suppose that the firm is told, before choosing its level of production, that the government will measure the amount of pollution that the firm generates and charge the firm a tax that is exactly equal to the social cost of that quantity of pollution.
This policy generates a tax schedule that translates the amount of pollution generated into an amount paid by the firm. If the firm knows that it faces this tax schedule, its costs of production will include the social cost of pollution, along with the costs of labor, materials, energy, and the like.
The same principle applies to financial firms. So what’s the hang-up? A minor headache called politics (as Kocherlakota concedes). The fight over financial reform recently showed that Congress lacks the gumption, and to be fair probably the votes, to raise taxes on banks. Pity.
Related:
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- Financial Industry Warns that Bank Tax Would Have Dire Effects
- Why a Financial Transactions Tax Makes Sense
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