Taxing Finance

• Author: Geoff Gottlieb, Gregorio Impavido, and Anna Ivanova
• Position: an Economist and and are Senior Economists in the IMF's European Department.

A deep and well-functioning financial sector—which includes banks, investment firms, pension funds, and insurance companies—can offer great advantages to society. Firms have better access to the capital they need for investment. Individuals can better smooth their spending over time—saving in good times to prepare for bad times and retirement. By connecting those with too much savings and those with too little, a strong financial sector can raise long-term growth.

But, as the 2008–09 global economic crisis showed, the financial sector can also impose significant costs on the broader economy. Among other factors, the combination of excessive risk taking, high leverage, and heavy reliance on short-term wholesale finance triggered heavy losses for many important financial institutions in advanced economies. Governments feared that if major institutions went bankrupt, the effect on production and employment would be enormous. To stave off a systemwide financial collapse, governments in North America and Europe spent an average of 3 to 5 percent of GDP to support the financial sector directly. Governments also issued guarantees and other commitments that totaled about 17 percent of GDP on average. Even though the authorities kept the financial system from imploding, the crisis still triggered a global recession that resulted in a cumulative loss of output of about 25 percent of GDP (IMF, 2012).

Many European governments have recently introduced taxes on the financial sector to recover the fiscal cost of the bailouts. But discussions continue in Europe on the role that financial sector taxation could play in safeguarding the financial system. To that end, the European Commission has proposed a coordinated financial transactions tax for all 27 member states.

Taxation of the financial sector can be seen in two ways. First, when applied to risky behavior, taxes can be a corrective tool that reduces the probability of future crises. And second, financial sector taxes can also provide a means of adding to government coffers the resources necessary to cover costs of past and any future crises.

Taxation could supplement regulation of financial institutions because it can be focused on risks to the overall financial system rather than just on individual financial institutions (Keen, 2011). While regulations like minimum capital requirements create buffers that help individual institutions absorb losses, taxation can provide the resources governments need to intervene systemwide. Furthermore, over time, taxation allows for more efficient distribution of losses—by collecting from the current generation to pay for the losses its actions might impose on future generations.

Eliminating distortions

Financial sector taxes could be used to eliminate distortions in the tax system that may have contributed to the recent financial crisis. For example, the fact that a value-added tax (VAT) is not applied to financial services may help explain the disproportionate growth of the financial sector in recent years. Similarly, the ability of financial—as well as nonfinancial—firms to deduct interest payments from their taxes may have encouraged excessive reliance on debt rather than equity financing.

But proponents of financial sector taxation want to do more than reduce existing distortions. They want to design a tax that can make the financial sector bear the social cost of risky behavior. The recent crisis demonstrated that the consequences of a financial sector crisis are not limited to those directly...