Fed’s Kocherlakota Argues for Bank Taxes Related to Risk « The Washington Independent

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Here’s my preferred policy. The firm is told that the government will estimate the expected, discounted value of bailouts that the financial institution (or any of its stakeholders) will receive in the future…. [This] estimate will depend on many firm choices and attributes, including its leverage ratio, the maturity structure of its liabilities, the risk characteristics of its investment portfolio, and its incentive compensation schemes. For example, the expected bailout will be higher for firms with highly risky investments than for firms with less risky portfolios.

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Having done this calculation, the government then charges the firm a tax that is exactly equal to the expected discounted value of the firm’s bailouts…. The tax amount exactly equals the extra cost borne by the taxpayers because of bailouts, appropriately adjusted for risk and the time value of money. Knowing that it faces this tax schedule, the firm no longer has an incentive to undertake inefficiently risky investments. Its investment choices will be socially efficient. It is useful to tax a financial institution producing a risk externality, just as it is useful to tax a firm producing a pollution externality. The purpose of the tax in both instances is to ensure that the firm pays the full costs — private and social — of its production decisions.

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The Senate bill proposes no new taxes on financial institutions, unless some fail. In that event, taxes could be levied on surviving large financial institutions, regardless of whether or not they had actually engaged in excessive risk-taking. The House bill has a new risk-based assessment on large banks and hedge funds. Such a risk-adjusted tax should have desirable incentive effects on the targeted firms. However, the tax will end once it has raised $150 billion. This cap is problematic, because once the tax is ended, so too will its desirable incentive effects.

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Why do the bills fail to include new levies of the kind that I propose? In my view, both bills significantly understate the extreme economic forces that lead to bailouts during financial crises. Indeed, the opening language of the Senate bill actually declares that it will end taxpayer bailouts. This objective is laudable. But it is not achievable—and thinking that it is can lead to poor choices about the structure of financial regulation.