New legislation would impose an excise tax on future sovereign debt issuance if a country strategically defaults
How do you hold someone accountable for failing to pay their debt when you've got no jurisdiction to do so? This is a question that the U.S. government struggles with when it comes to deadbeat nations. Although some countries default due to serious fiscal problems, at other times nations simply decide to default on debt and keep the money loaned to them by investors. While investors can attempt to sue these foreign governments in U.S. court, sovereign nations can simply ignore what a U.S. judge orders. A legislative proposal being considered in the New York State Assembly attempts to solve this problem with an excise tax.
First, let's better explore the problem that strategic sovereign debt default poses. One country infamous for this behavior is Argentina, so let's use it in a simplified, fictitious example. Imagine if Argentina goes to Goldman Sachs and asks the bank to underwrite $100 million in unsecured Argentinean sovereign debt to sell to U.S. investors. It then, for simplicity, sells that entire bond to New York Life. The insurance company expects to earn an 8% coupon for 5-years.
Instead, however, Argentina smiles, winks, and decides to default -- not because it can't afford to pay, but because it would rather have $100 million than good credit. This leaves NY Life with a $100 million loss on the investment. As a result, its profit is reduced by that amount. New York's corporate tax receipts are also smaller. If New York state has a corporate tax rate of 7%, then the loss would cost New York taxpayers $7 million.
Obviously, this is an undesirable result, both for investors and taxpayers. One attempt at solving this problem occurred about two years ago, when H.R. 2493 was introduced in Congress, sponsored by then Rep. Eric Massa (yes, the alleged tickler). The bill sought to ban deadbeat sovereigns from U.S. capital markets. The proposal died in committee.
But New York remained concerned with this problem. After all, the state contains the heart of the U.S. financial industry, so a large chunk of its tax revenues come from financial firms that stand to lose from deadbeat nations. So earlier this year, State Sen. John DeFrancisco introduced a bill proposing another way to solve the problem. The state doesn't have to power to ban sovereigns from U.S. capital markets, however. Instead, this bill would impose an excise tax on firms that provide services to deadbeat nations for subsequent capital market offerings. The spirit of the bill is to recover a portion of the lost income tax revenue to New York taxpayers that the sovereign debt losses caused.
If this bill is enacted, will it do more harm or good? The purpose is to encourage these sovereigns to live up to their obligations, but the stakes here are pretty high. Think about the example above within a deadbeat nation's mindset. Would you rather a) pay that $100 million you owe, b) pay much higher fees (to neutralize the excise tax) to Goldman to underwrite a future debt offering, or c) bring your next debt offering to HSBC in London? This isn't a hard call for Argentina: it would be headed to Canary Wharf.
Moreover, it doesn't seem like much is really accomplished here. New York investors could still purchase this debt from HSBC, which would still result in losses to New York taxpayers.
So what's the result? Those underwriting fees move overseas. U.S. banking revenue declines, overseas banking revenue rises. Perhaps New York state taxpayers would be better off preserving their high paying Wall Street jobs and tax revenue from banks instead of driving that business to London and Hong Kong.
A Strange, But Not Unique, Problem
What's really puzzling about this problem is why it exists in the first place. The big loser in this scenario isn't NY State -- it's the investor. The tax revenues are a pittance compared to the principal losses on the defaulted sovereign debt. Why isn't the market working here -- why are investors willing to purchase debt after a sovereign has strategically defaulted? The going assumption above is that there would be a market for another debt issuance, but those investors would presumably insist on a very high risk premium the second time around, which should serve as deterrent enough to prevent deadbeat nations from habitually defaulting.
This problem isn't isolated to sovereign nations, however. As we have come to learn, strategic default has been a very common practice in the U.S. mortgage market. Some homeowners with underwater mortgages are just walking away, rather than pay more than a home is worth. In non-recourse states, these borrowers may owe banks little to nothing. Many of these mortgages are in pools backed by mortgage-backed securities. Many of those MBS are likely held by New York-based investors. The losses that result -- just like the sovereign debt default losses -- are costing New York taxpayers millions. Should New York also impose an excise tax on lenders who provide loans to these strategic mortgage defaulters going forward?
Finally, you have to kind of appreciate the potential hypocrisy here. You've got the U.S. calling out other nations for defaulting on their debt when they have the ability to pay. Does that sound familiar? We may soon become a deadbeat nation. The U.S. is currently on the brink of effective default, which will occur in August if the debt ceiling isn't raised. Of course, if Congress passes a new debt limit, then default can be easily averted.
And this raises a really, really fun question: if the U.S. defaults due to political bumbling, should New York impose an excise tax on any bank that issues U.S. debt in subsequent months? (Unfortunately, the bill only applies to "foreign states.")
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