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To Tax or Not To Tax?

I discussed the subject of financial transactions tax in the previous year and in my year-end message 2009. In then discussions I was pondering on the combination of the bank mezzanine (conditional or event-driven) capital which can be used as the temporary capital and liquidity booster and the insurance model for systemic shock events in the financial system. In this discussion, I am getting back to the subject once again in the light of new suggestions and proposals.

Why is the idea of taxing and levying financial institutions not good? Let’s take a look at the problem of taxes by following the present perception of the banking system as the self-service business. The corporations earn money by producing goods and services in the real sectors. The banks and other financial institutions earn money by providing financial services or speculating in financial markets. The government earns money by taxing corporations and banks. Looks pretty good – everyone is in the business of earning money.

The corporations use undistributed earnings to commit capital investments, to expand operations and maintain fixed assets. The banks use undistributed earnings to build up capital, to create liquidity cushion and earn more money. The government uses the expropriated money to develop the real economy, financial and social systems of the state. Looks pretty good – everyone is aware of how to use the earned money.

No one likes to pay high taxes and pay too many taxes. When the government wants to give it somebody hot, it raises taxes and tariffs, let alone other approaches. When somebody has been grilled, it gets frustrated and tries either to find the scapegoat or to make an escape. When the scapegoat has been found, it pays the whole price. Following this chain, when the government raises taxes for corporations and banks, they get frustrated and try either to find a proper scapegoat or to make escape of taxes and levies.

I wonder who is going to be the scapegoat. The man-in-the-middle will never pay the whole price itself if there is someone underneath. So the first reason why the additional levy will not work as it is supposed to work is that the man-in-the-middle will transfer costs to the man-in-the-end – the scapegoat. It is absolutely true for the financial institutions, because they are fiscal pipelines – the pure man-in-the-middle. The weak payers will be forced to go away and the strong players will become stronger.

The second reason has to do with the implementation. Things always sound great on the paper, but when it comes to the implementation stage there are many life factors that break the illusion of perfectness.

Just look at the theory of efficient market. The market might be efficient, if it were driven by machines which use strict computer models. But there are always human beings in the center of any market and computer model, with their emotions, their world outlook and perceptions, their problems and excitements, their wishes and interests. The market is not driven by cold-blooded machines, but hot-blooded humans. That is why it is not efficient, but emotional. So to counterbalance the theory of efficient market, there is practice of emotional market. And the business of hedge funds proves it.

There are thousands of financial transactions executed daily. And each must be reported to the regulatory entity for the taxation purposes? Or you want to obtain consolidated report on foreign transactions of each financial institution? And how multilateral transactions will be taxed? And, and, and… Such a fix does not look like a pair of crutches for the financial market, but like a limousine with the gold and diamond inlay. This limousine must be maintained and parked carefully.

Definitely, financial institutions will be required to adapt their reporting and accounting systems to the new requirements. As life proves, any brand-new solution will have a lot of bugs by default. Definitely, such the complex solution involving players around the whole world will have a lot of loopholes and bugs and will look too weird. The financial world will get another puzzle to assemble and to cheat on.

The third reason is the usage of taxes. It is said, it is not good to use the insurance model, because corpulent banks will be sure that they will be bailed out anyway and will continue cheating. Well, under the existing financial system architecture corpulent banks can always be sure that they will be bailed out, should the need be. Small banks will always be allowed to fail, but the crush of corpulent bank will cause a lot of damages. Thus the discount window will always be opened for it.

Under the existing financial system, the government will always use the taxpayers’ money to support its players – somebody must pay the price when it comes to the self-service without proper constraints and regulation. Everything has its price and everything has two sides – the free market as well. So it does not matter how many taxes you will strip of banks – you will always pay the price. That is why all appeals not to use the insurance model, because it makes banks over-confident, are nothing but verbal bubbles.

Moreover, the very nature of taxes is such that if someone pays the tax, she has the right to demand the appropriate support and protection, if it were a person, a merchant, a corporation or a bank. The tax is a sort of a moral and unconditional commitment to protect. To think other way around is a cheating. And if you have failed to create the relevant environment, to establish the market protection mechanism and define the efficient game rules, it is your fault first of all, not of those who were smart enough to leverage your weaknesses and provided freedoms to prosper and get bargains.

Because of these reasons, I prefer the insurance business model. It perfectly matches to the existing system architecture and allows earning money that can be reinvested in real sectors. The combination of the insurance fund, bank mezzanine (event-driven) capital, insurance premiums and conditional commitments to protect allows creating pretty simple, straight-forward and easy-to-implement business model. Providing some large banks may be stripped off the bank license as the result of restrictions on the proprietary trading, such the insurance model can compensate them for the closure of the discount windows and for discontinuing the deposits insurance scheme.

If the systemic shock event has been detected and the insurance event comes, the fund can invest in the mezzanine capital to boost the capital and liquidity of the insured bank according to the contract terms (repayment options, amount, rights etc.). In this case the fund must have the relevant control body and implement the efficient early warning system. The government may help with the appropriate rulers and regulations – let it also work off the taxes it earns. Such a pair of crutches is much better and more useful for the economy and financial system, taking into account that taxes have the property to dissolve.