Upcoming paper: ‘Bank Taxation and Regulation’

Andrew Mullineux and Sajid Mukhtar Chaudhry are working on a paper titled “Bank taxation and regulation”. We are aiming to submit the paper to the “Financial Engineering and Banking Society” (FEBS) conference on the topic of “Financial regulation and systemic risk” to be held in Paris from June 6-8 2013. The deadline of submission of a completed paper is February 8. Following are some of the key points of the paper:

The idea of the paper is to highlight the drawbacks of regulations, as their focus is micro prudential and to provide a private buffer for the idiosyncratic risk of banks as compared to the taxation, whose focus is macro prudential and to provide a public buffer for the systemic risk of banks, a factor that has been broadly ignored in the run-up toward financial crisis. We will substantiate this by providing extensive literature review on the topic.

We regard bank regulation, such as deposit insurance and liquidity requirements, as a non-revenue raising tax on risk taking that should be used to discourage excessive risk taking.

Current tax rules encourage excessive debt because of the tax deductibility of interest on debt. This tax deductibility needs to be removed to give debt equal treatment with equity, which will decrease the leverage of banks. Here, some consideration should be given to smaller banks, as it is difficult for them to raise equity. Furthermore, we are reviewing capital gains tax and corporate taxes to reduce distortions. The aim is to eliminate the taxpayer subsidy of big banks (“too big to fail” banks enjoy an implicit bailout guarantee from tax payers) and level the playing field so they cannot raise funds more cheaply than smaller potential competitors. In sum, the emphasis is on fairness and consistent and equal treatment throughout, which requires differential taxation of implicitly subsidised banks and to remove bias to over use of financial services and debt.

The taxation of stock options and other performance-based remuneration incentivizes managers to take excessive risk in the short term. This needs to be changed and should be aligned with long-term interests of banks. One idea is to increase the “debt” component of banker’s remuneration. It will probably lead to debt overhang problem.

The European Commission is considering a Financial Transactions Tax (FTT) and is supported by Liikanen Report; the UK also has a stamp duty on the sale of shares and property. However, the ‘Mirrlees Review’ of the UK tax system and the recent ‘Henry review’ of the Australian tax system both counselled against transactions taxes because they are economically inefficient, and instead advocate VAT (GST). Currently, financial services are exempted from VAT, meaning that banks cannot reclaim input tax paid on their purchases. This put banks into disadvantage and might lead them to take excessive risk in search of profits. We, therefore, are also of the view that VAT (GST) is economically more efficient, although operationally difficult, and financial services should no more be exempted from VAT. With the Removal of exemption of VAT, the burden has to be borne by the final consumers but it might reduce the unnecessary use of financial services by them, thereby, reducing the negative externalities arising from excessive use. However, we are reviewing these documents to come up with a solid solution before we submit to FEBS conference.

We shall finally compare and contrast practices in different countries (especially New Zealand, Australia, South Africa that seem to apply GST on financial services).

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