Legal Briefing

Tax and social policy

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Corporate and commercial | 01 March 2010

The world of tax is quite interesting at the moment – to me, at least – because it brings into sharp focus the way that tax is used as an instrument of policy and what role it is playing in the field of social policy. It is hardly news that the state of public finances in most western economies is, to be charitable, delicate. No doubt the finances will be redressed, to an extent, by cuts in spending. However, it is equally clear that some of the improvement will have to come from an increase in public revenues.

Tax as policy

Taxes are going to rise and it will be interesting to see which areas are targeted. However increases in tax or changes to the way taxes are assessed are not only dictated by economic necessity. In some cases, tax is used as a stick with which to beat some sections of society for their role, or their perceived role, in the current financial crisis. This means that the role of tax at the macroeconomic level is more obvious than usual. By bringing this aspect of the process to the fore, the debate concerning the various policy initiatives announced in response to the economic downturn illuminates the debate as to the aims of tax policy in more general terms.

The process started at the end of last year. Alistair Darling, in his Pre-Budget Report 2009, announced that the UK would introduce, with immediate effect, a levy on discretionary bonuses. The announcement was interesting because the government’s stated purpose in introducing it was not to raise revenues (the amount that it was predicted to generate was a modest £500m – but more about that later), but to make it so expensive to pay bonuses that banks would avoid large pay-outs. The fact that the measure was stated to expire at the end of April 2010 and that the banks, rather than individuals receiving the bonuses, were the payers of this tax emphasised the goverment’s purpose. It seemed that the government was simply asking for a little restraint.

Soon after the announcement by the UK, both the French and German governments announced that they broadly supported this approach, and would be looking at introducing their own versions of it. The details of the French proposal are remarkably similar to the UK proposals and, once again, seemed to be aimed at ensuring that bonuses were withheld rather than generating tax revenues.

After Christmas the US announced that it would introduce a new levy to ensure that the losses suffered by taxpayers under the Troubled Asset Relief Program (TARP) would be recovered. This was clearly a different approach. It did nothing to prevent bonuses being paid and seemed to be more genuinely aimed at generating tax revenues. Barely ten days later, the US announced drastic legislation aimed at reducing the size of banks and ensuring that there would be no further bailouts.

In this article, I look at the response to the so-called ‘Obama Bank Tax’, and draw also from European reactions to the banking crisis to identify the role and uses of tax in policy.

BARACK OBAMA’S BANK TAX

The financial crisis responsibility fee (FCRF) was announced by the US administration on 14 January and, in hindsight, can be seen as the first of two major initiatives of the US administration in the banking area. At the time of writing, it is the second part of the package, announced on 21 January, which has attracted the most comment – in the UK at least. By way of reminder, the Obama administration is suggesting that:

  1. banks (as defined for US regulatory purposes) will no longer be allowed to own, invest in, or sponsor hedge funds, private equity funds or proprietary trading operations; and
  2. further consolidation in the banking sector is to be ruled out.

The FCRF is the first of the two reforms and is tax based. Under the proposals relating to it, financial firms with more than $50bn in consolidated assets would be required to pay a fee of 0.15% of so-called covered liabilities. The fee would apply to banks, thrifts and other companies owning insured depository institutions, and would apply to US-based firms, as well as US subsidiaries of foreign firms. The stated purpose of the FCRF is to recoup the estimated losses of the US government under TARP introduced by the US government to bail out financial and other institutions at the height of the credit crunch. The cost of TARP is currently estimated as $117bn and according to the US Treasury’s own estimates, it will take 12 years for the FCRF to recoup those losses. The way in which the FCRF is calculated is also interesting as the fee will be based on the institution’s total consolidated assets less its tier 1 capital. This is why the proposal refers to the FCRF being a percentage of covered liabilities.

The reaction to these proposals in the UK has been to say that, while the UK is comfortable with the approach taken by the US administration both on the FCRF and the restrictions on the size of banks, there is no need to do the same here. The increase in tax to 50% and the tax announced on bank bonuses are seen as different ways of achieving the same thing. However, these comments need to be treated with some caution as the UK and the US are at very different points of the political cycle. In the UK a general election will have to be called in the first half of 2010 and both leading parties have been relatively tight-lipped about their proposals for the reducing the UK budget deficit. By contrast, in the US the Obama administration recently suffered a serious upset when the traditionally democrat seat previously held by Senator Ted Kennedy went to a republican. So there is perhaps more willingness in the US to announce significant reforms now. That said, the FCRF is targeted at banks, and they remain a popular target in both countries.

The reaction to the FCRF has been interesting. There are several arguments consistently deployed by those who oppose it that throw further light on the rationale for its introduction:

    • The FCRF hits the wrong taxpayers. By linking the FCRF to the repayment of losses under TARP, the Obama administration has opened the door to this argument. A significant part of the losses suffered under TARP arise from support made available to two of the US’s large automobile manufacturers: General Motors and Chrysler. They are not included in the list of payers of the FCRF. Neither are Fannie Mae and Freddie Mac, the US lenders that the government had to step in to rescue.
    • The cost of the tax will be passed on to consumers. This argument accepts and presupposes that the FCRF is aimed at punishing reckless behaviour but suggests that the wrong people will be targeted. The Obama administration was careful in this respect to choose only institutions with an asset base of $50bn or more. Some of the supporters of the tax point out that this will act to prevent the cost being passed on because larger firms will not drive prices up for fear of losing business to smaller institutions. While this is probably true for some lines of business (retail banking, for example) it is not such a convincing argument when it comes to others, such as merchant banking, where competition is much more difficult, and small players find it harder to compete with larger and more established firms.
    • The tax system is not meant to be used to punish people. In an interview reported on Bloomberg.com on 20 January, this was the line taken by Warren Buffet (whose company, in the interests of full disclosure, holds shares in both Goldman Sachs and Wells Fargo, both of which will be required to pay the FCRF). Warren Buffet is quoted as saying:

‘I don’t see any reason why they should be paying a special tax. Look at the damage Freddie and Fannie caused, and they were run by congress. Should they have a special tax on congressmen because they let this happen to Fannie and Freddie? I don’t think so.’

  • Another argument used against the FCRF (that companies which have repaid the TARP funds advanced to them should not be required to pay the FCRF) is a variant on this theme. Taken at face value, this type of argument suggests that the tax system should be policy free. In their defence, those who advance this argument might make the point that what they object to is not that the tax system should be used to punish people but that it should do so retrospectively. There is some moral weight to this argument because the bankers whose irresponsible behaviour is being so loudly castigated were seen as creators of wealth and solid citizens until recently. However, this argument is not entirely convincing. There is an undoubted cost to the financial rescue packages that some governments introduced. Is a levy on banks justified in this context? Yes, if the levy is sensibly set and administrated.

Unintended consequences

It is worth looking at the FCRF and also at the response of the UK government, in the context of another often-raised question in the realm of tax policy: the law of unintended consequences. Some have seen the FCRF as a way to punish bankers or financial institutions, but will the FCRF really have that effect? It could be said that the FCRF and the very neutral language that was used to announce it will have the opposite effect. In some ways, it could be said to be an acknowledgement that taxpayers will always have to step up to rescue banks. Perversely, those who pay the tax could be encouraged to believe that the FCRF is a form of insurance and since they have paid for it, they might as well use it. Although this may be a tortuous piece of reasoning, the bank bonus tax in the UK reminds us that taxpayers may not always respond to tax policy in the way initially envisaged by those who frame it. It is clear that, when Darling announced the introduction of the bank bonus tax, the intention was that banks would be discouraged from paying large bonuses. But in fact, this has not happened. At the time of the PBR, Alistair Darling estimated that the bonus tax would only raise a relatively modest (at least in the context of the UK budget deficit) £550m. It is now expected that the tax will raise substantially more because in general it has been wholly ineffective in preventing banks from paying bonuses.

There is no guarantee that the FCRF will ever become law and it maybe that some of the debate around it will be largely academic. However, the way it was framed and the way people have responded to it is a reminder that, although tax legislation may seem dry and soulless, it is often at the very heart of social policy.