Obama's Bank Tax

President Obama this week unveiled a plan to raise about 100 billion dollars by taxing big banks. The overall thrust of the plan - replenishing government coffers with a slice of the profits made by institutions that were saved from destruction by government largesse - seems fair. And the U.S. Treasury could surely use the cash. So I support this effort to get taxpayers some of the money that is rightfully theirs.

However, this tax is far from ideal and raises some troubling questions about the future role of government in the financial sector. A system in which politicians run about deciding which industries they like and which they would like to tax is a bad one. Tax policy should be predictable so that investors can confidently invest without fear of retributive taxes. And taxes should not target certain industries; targeted taxes interfere with the free market and hinder economic growth. Another unfortunate consequence of a system in which Congress picks winners and losers in business is that such a system encourages lobbying and tends to corrupt the political process. Perhaps worst of all, this tax does little to remedy the hyper-leveraged risk taking that brought down the financial system in the first place. In fact, the tax has the unfortunate consequence of increasing leverage by reducing the firms' equity.

One desirable feature of the tax is that it hits bigger firms harder (the amount of tax owed is a percentage of certain types of assets and only kicks in if a firm has 50 billion in such assets). This may in some small way reduce the too big to fail problem, but the benefits of being big will still outweigh the costs of the tax. Other than that, the proposed levy does little to reform the financial system to make it more stable in the future.

A variety of superior alternatives exist. The first that comes to mind is an F.D.I.C. controlled investment bank bailout fund modeled after the current F.D.I.C. deposit insurance program. Firms would contribute to an annual fund that would be used for future problems and the amount contributed would be based both on a firm's size as well as an estimate of its risk. An important feature of an F.D.I.C fund would be the orderly wind-down of any firm that needed assistance. The F.D.I.C. has already successfully wound down hundreds of failed deposit banks and could extend this expertise to the investment bank behemoths. Funds would not be used to keep the firm alive or to bail out investors. Only customers would get bailed out and even they might be forced to take a haircut on their assets.

Another alternative would be a tax that accounts for leverage as well as size. Banks' excessive leverage was a much more significant factor in the financial meltdown than was size.

It is also worth quickly reviewing some T.A.R.P. history to point out how this tax is inconsistent with earlier theories used to justify the terms of the bailout. Many argued - including myself - that the terms of any bank bailouts should be much harsher for the banks' investors. Paulson - in conjunction with a Congress controlled by Democrats - doled out cash on generous terms. They argued that they were not trying to punish banks, but to encourage lending. Despite the fact that Warren Buffet was simultaneously extracting much better terms for his investment in Goldman Sachs, Paulson believed that he should not do so on behalf of the taxpayers who employed him. Had the government demanded much larger equity stakes and/or concessions from bondholders, taxpayers would have fared much better and banks would have learned a much sterner lesson about the dangers of excessive risk.

Obama is doing the right thing by trying to capture some of the profits that were made possible by taxpayers. But his tax proposal is a blunt tool that undermines political integrity and confuses investors. It also fails to discourage the types of behavior that caused the financial crisis in the first place. It would be easy to improve this bill.