A Better Kind of Bank Tax

The Obama administration and key Democrats want to tax banks to replenish the money they've lost on the bailout fund, also known as TARP. OK, fine. But taxes in general are an effective way to discourage things we don't like, such as risky betting. Should we tax these banks permanently?

Minneapolis Federal Reserve President Narayana Kocherlakota says, absolutely. In a speech last week called "Taxing Risk," he compared bank risk to pollution. Pollution costs something, in health risks and ecosystem depletion, but we don't account for its impact in the price we pay for energy. Risk costs something, too. It can make large financial institutions fail, and economies crumble.

"Bailouts will inevitably happen," Kocherlakota says. (Yup.*) Riskier behavior should make investors demand higher interest rates (just like we should pay big polluters more for their energy). But if investors suspect that bailouts are practically inevitable, they'll lend with low interest rates, thinking there's squat chance of failure. "In this way, the expectation of bailouts leads to too much capital being allocated toward overly risky ventures," Kocherlakota says.

So this Fed Prez calls for a bank tax. But how should the government decide how much to tax banks?

That's where it gets interesting. You could leave leave it up to regulators to rifle through banks' portfolios. But honestly, who trusts bank regulators, these days? Not Narayana Kocherlakota (a bank regulator). So he has another strategy for designing a bank tax. The government would issue a "rescue bond" that reflected the market's belief in the level of risk at every financial institution (a Citi bond, a JPMorgan bond, etc). There would often be no market for many of these bonds, because some banks simply aren't at risk to fail. But as Citi took on more risk, interest rates would creep on Citi bonds, the government would assess a proportional tax on Citi.

Does this remind you of something? The government is issuing its own version of a credit default swap -- an insurance policy that measures that the likelihood that a security will default -- on entire financial institutions to determine which banks deserve a punitive tax for taking on too much risk. Of course, this makes you wonder why the government would have to get into the game at all. Why not just monitor the private CDS market and instruct regulators to consider new taxes on banks whose assets look particularly risky? You'd face the same transparency challenges and misleading guessing games in both markets.

This is a wacky idea, indeed. And Kocherlakota acknowledges that it's wacky idea. But it's kind of fascinating too. "To me it makes a lot more sense than taxing bigness," says the Tax Policy Center's Howard Gleckman, "because bigness isn't necessarily bad. It's what you do with your bigness that can hurt you. It's a smarter way to look at this issue of risk. But whether it would work, I have no idea."

Me neither.

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*Some Democrats and liberal commentators, responding to GOP claims that the liquidation fund was a "bailout fund," went too far by arguing that the Senate bill outlaws bailouts, for ever and ever, amen. No way. If too many large, intertwined banks fail at the same time, we'll almost certainly bail some of them out.