Downsizing the Financial Sector
The argument advanced above was to the effect that the financial sector had, in some significant senses, become ‘too large’, and in particular the ways in which the financial sector had expanded in recent decades has been through the growth of financial markets and the extent of trading in existing financial assets. It can further be argued that the financial sector is often undertaxed relative to non-financial sectors. The possible use of taxes to influence the size and nature of the financial sector is now considered.
Financial Transactions Taxes
The case for financial transactions taxes considered here comes from the discouragement of transactions in financial assets. Keynes (1936) advocated what would now be termed a financial transactions tax which
“might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States” (p. 102). Keynes (op. cit.) saw the changing balance between what he termed enterprise and speculation as disadvantageous. “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism—which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object” (p. 101).
Financial transactions taxes (FTTs) are often advocated for their tax revenue possibilities. The considerations here are more that FTTs would reduce the volume of such transactions viewed as excessive with possible effects on market volatility and absorbing resources.
The underlying rationale for financial activity taxes (FAT) can be viewed in terms of the relative undertaxation of the financial sector in that indirect taxes such as value added tax are often not applied to the financial sector. There are, of course, examples of where forms of indirect taxation (other than financial transactions tax) are applied to parts of the financial sector. This can be complemented by the use of FAT to seek to reduce the size of the financial sector. The argument can be put that levying taxes on a sector will have effects on the demands for the goods and services of that sector. The tendency to undertax the financial sector would imply that other sectors are relatively overtaxed and those sectors perhaps relatively smaller than they would have been, and the financial sector relatively larger.
“a FAT would effectively be a tax on value added and so would partially offset the risk of the financial sector becoming unduly large because of its favorable treatment under existing VATs. For technical reasons, financial services are commonly VAT-exempt—which means that, purely for tax reasons, the financial sector may be under-taxed and hence perhaps ‘too big’... Taxing value-added in the financial sector directly would mitigate this” (emphasis in original, IMF 2010, p. 22).
“The EU’s common value added tax system has generally exempted mainstream financial services including insurances and investment funds. Article 135(1) of the VAT Directive provides an exemption from VAT for most financial and insurance services”. There is an option for member states to tax financial services. “The difficulty is, however, to technically define the price for specific financial operations. Around two-thirds of all financial services are margin based which makes the implementation of the invoice-credit VAT system very difficult in this respect. In practice however this difficulty seems to be surmountable—for instance in Germany when the granting of loans is subject to VAT under the option to tax, an acceptable methodology seems to have been found to tax these margin-based operations” (EC 2011, p. 13). Insurance premia can also be subject to being taxed (as in the UK). EC (op. cit.) presents estimates of the potential tax advantage of the VAT exemption of the financial sector and put it at the order of 0.15 percent to 0.20 percent of GDP. “In summary, the VAT exemption for a large share of financial services is an important issue. It possibly results in a preferential treatment of the financial sector compared with other sectors of the economy as well as in distortions of prices” (p. 15). Buettner and Erbe (2014) find that a 4 percent FAT in Germany would generate similar revenues and welfare effects as the repeal of VAT exemption (at a rate of 19 percent) for the financial sector.
A FAT is essentially a tax on the sum of profits and remunerations of the financial sector, and, as such, has features of being close to a variant for a value added tax on the sector since sum of profits and remunerations is a good proxy for value-added. Cannas et al. (2014) then note that a FAT “present little distortions to the extent that it can be designed to mostly tax the rents of the sector” (p. 4). The European Commission (2011) considered three variants of a FAT—(i) profits of financial institutions in cash-flow terms plus remuneration paid by the sector; (ii) as (i) with remuneration replaced by notion of ‘excessive remuneration’, (iii) sum of cash flow profits above a specified return on capital and ‘excessive’ remuneration.
“A FAT could also in theory reduce the size of financial institutions to the extent that the tax is passed through into higher prices for financial services and that the demand for these services is sufficiently elastic. The passthrough into high prices is more likely under the broader design of the FAT because for the same rate the tax would be higher but also because smaller designs of the FAT would increasingly target the economic rent and not the normal profit. A FAT would however normally have little effect on leverage” (Cannas et al. 2014, p. 19).
The proposals for financial activity taxes have received rather little attention in recent years, particularly relative to those for a financial transactions tax. Those two types of tax are not mutually exclusive as the FTT relates to transactions in specific financial assets (depending on the proposals), whereas the FAT relates to the value added of financial institutions. They are both revenue raising and would tend to reduce the size of the financial sector.
A FAT would help remove the relative undertaxing of the financial sector through its general exemption from VAT (and the counterpart the relative overtaxing of the real sector). From that perspective, it can clearly be argued that there are distortions in the tax system which favour the financial sector over the non-financial sector, and this line of argument would also point to the financial sector being ‘too large’ (and the nonfinancial-sector ‘too small’).
There could be elements within a FAT, depending on its precise design, of an ‘excessive profits’ tax. The IMF (2010) argued that “with inclusion of profits only above some high threshold rate of return, the FAT would become a tax on ‘excess’ returns in the financial sector. As such it would mitigate excessive risk-taking that can arise from the undervaluation by private sector decision-makers of losses in bad outcomes (because they are expected to be borne by others), since it would reduce the after-tax returns” (p. 22). It is undoubtedly the case that there has been, at least up until the financial crisis, a boom in the profits of the financial sector and a shift of profits from the non-financial sector to the financial sector. In that regard, however, it should be observed that what are deemed non-financial corporations often make a substantial portion of their profits from financial activities. The questions which would arise in this context are, first, whether the financial sector should be singled out in this manner for its ‘excessive returns’ to be taxed, and not the ‘excessive returns’ in other sectors. In a similar vein, it could be asked whether excessive risk-taking has particularly severe consequences in and for the financial sector. A further question would be how well targeted would the mitigation of excessive risk-taking be, and whether this form of the FAT would be a valid instrument (particularly as compared with forms of regulation and codes of conduct for the determination of variable pay and bonuses).