The Bank Tax

President Obama has proposed a special tax levied on large financial institutions.  In general, I am skeptical of narrow-based taxes, as they feed a particularly nasty kind of politics, where the majority gangs up on a minority.  And I am turned off by the populist rhetoric coming from the administration, which suggests the issue pits Wall Street fat cats against ordinary Americans.  Nonetheless, on the economic merits, there may be a case for the bank tax.

One thing we have learned over the past couple years is that Washington is not going to let large financial institutions fail.  The bailouts of the past will surely lead people to expect bailouts in the future.  Bailouts are a specific type of subsidy--a contingent subsidy, but a subsidy nonetheless.

In the presence of a government subsidy, firms tend to over-expand beyond the point of economic efficiency.  In particular, the expectation of a bailout when things go wrong will lead large financial institutions to grow too much and take on too much risk.

You may recall that I made precisely this argument regarding Fannie Mae and Freddie Mac some years ago when I was CEA Chair.  (No, I was not a prescient genius.  The potential problem was apparent to anyone who cared to look.)  But now the problem of implicit subsidies is far more widespread.  We have in effect turned much of the financial system into government-sponsored enterprises.

What to do?  We could promise never to bail out financial institutions again.  Yet nobody would ever believe us.  And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax.  If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

Will the tax law in fact be so well written?   It certainly won't be perfect.  But it is possible that it will be better than doing nothing at all, watching the finance industry expand excessively, and waiting for the next financial crisis and taxpayer bailout.