Budget Weeds That Matter: Scoring the Financial Fee as the Pigouvian Tax It Is

The Tax Policy Center, a group whose work I always find useful and carefully done, is out with a preliminary distributional score of various proposals in the President's new budget due out Monday. It's always tricky to perform detailed analysis on policies that haven't been fully fleshed out yet, but I thought the TPC made a questionable assumption in distributing the impact of the financial fee.

To be clear, as I highlight below, TPC themselves raise questions about their choice so I'm not "dinging" them for an obvious mistake. But I think they've misinterpreted this tax policy, one I worked on myself back in the day, and in this type of analysis, your results are often dependent on such assumptions.

In this case, the scoring choice makes a difference, as it leads to an assumption that the fee/tax being would end up being paid by many more households across the income scale, though mostly borne by those at the top. But the way I and others see it, the fee is more likely to be by paid by a relatively narrow group of individuals engaged in excessive borrowing at large institutions, while the benefits of taxing such risky behavior will redound broadly to the rest of us.

The financial fee is a seven basis point (seven one-hundredths of one percent) tax or fee on the roughly 100 large financial firms with assets of at least $50 billion. Yet there's an interesting and important wrinkle here: the tax is not on profits or assets, as is typically the case. It's on leverage, the banks' liabilities...what they owe to others. And as recent history has revealed, the combination of size and leverage can be economically toxic when loans start to go bad.

In this sense, the way to think of this tax is not, as TPC does, as a typical corporate levy, but as what economists call a Pigouvian tax intended to discourage a negative externality. Such taxes, like "sin taxes" on alcohol and cigarettes, or taxes on a polluter, are designed to discourage behavior that has the potential to hurt the rest of us. Their purpose is to "internalize"--put back on the offending firm or individual--a cost that they are currently imposing on the rest of us.

David Dayen perfectly nails this point:

...the key to the plan is that it does not tax the bank's assets, or what they own; it taxes their liabilities, or what they owe.

In other words, it's a tax on bank borrowing, which punishes one of the key drivers of the 2008 financial crisis. By limiting bank borrowing, the tax would also reduce the risk of big bank failures that impose costs on the rest of the economy.

If the White House wanted to simply raise money, Obama would have proposed taxing the bank's assets, which are hard to reduce. But the tax on liabilities gives big banks a way to shrink gracefully. They can reduce their tax bill simply by cutting back on borrowing, and financing their operations through other methods, like selling shares of stock or retaining some of their earnings.

As you might imagine, to contemplate the incidence of a tax based on these assumptions, you'd get a very different result. The TPC, as is standard (though I would argue also questionable), scores the leverage tax as a corporate tax increase, assuming it is "...ultimately borne by investors in the form of lower after-tax rates of return and workers in the form of lower wages."

But as Dayen stresses, by diminishing the risk of excessive leverage by large banks, an activity that was a key contributor to the depth, length, and cost of the Great Recession, the tax has the potential to protect the jobs and wages of working people, not to mention the portfolios of investors.

To their credit, the TPC recognizes this possibility:

Note that different assumptions about the incidence of the tax and the distribution of the returns to capital could significantly affect the distribution of tax changes and the share of tax units with gains or losses from the proposal. For example, financial sector executives and investors might have benefited disproportionately from excessive risk-taking. To the extent that the tax discouraged such risk-taking, the costs of the policy would be borne primarily by very high-income financial sector participants (and the rest of society would benefit because there would be less risk of another financial sector collapse and resulting recession).

I'm not sure how they would plug that into their model. While it's absolutely appropriate to model the Pigouvian impacts of such taxes, it's much trickier than just assuming it works like an increase in a business tax rate. But that's not what it is, I don't believe that's what its impact would be, and I thus would urge them to treat it differently when they revisit this approach as more details come out.

This post originally appeared at Jared Bernstein's On The Economy blog.