July 24, 2009

The Taxman Cometh

This will be a long and slightly-econny post, so skip to the end if you want to avoid the thought process.

President Obama announced this week that he was considering a tax on “far-out transactions”, probably because everyone's quite peeved at Goldman's ostentatiously large compensation reserve. It’s not very clear yet what falls under the category of “far-out”; are we talking about all classes of derivatives, new financial instruments that have yet to be invented, or simply anything that the layperson can’t understand? The last might pose a slight challenge to our financial system, but it seems like this would be a good plan if we can set up a few caveats.

One of the nice underpinnings of this plan is that it reverts to the idea of rational choice models and incentive alignments. Codified regulation has always been a tricky proposition, especially when it comes to the financial system. What works for the courts and public life won’t necessarily work for the banks and the funds. Finance necessarily moves at a much faster pace than everyday life, rendering a system of law and arbitration less useful. The more elegant solution would be to tell financial institutions: Eat what you want, as long as you pay for your own dinner (and hospital costs if you get food poisoning).

In its current, inchoate form, the proposed exotic-instruments tax might basically be that banks pay an extra tax on revenue generated from origination, structuring and sale of such instruments. This doesn’t seem like it would be too hard to implement, as long as we can adequately define what comes under the category of exotic instruments (more on that later). We also would tax only institutions that originate the products, not upstream or downstream entities. For example, Company A has a cool stream of revenue coming in from intellectual property royalties. Bank B decides that it could package this stream of royalties and sell off tranches to different investors. We’d tax Bank B, on the idea that they’re the one creating the risk and that the effect would be shared across the supply side in the form of higher bank fees. If Bank C buys Bank B’s stuff, and repackages THAT with something else, that’s when we’d tax Bank C as well.

Some might argue that this effectively chills financial innovation and creativity. This, however, is precisely the idea: That institutions are forced to internalize the systemic risk their activities create. It seems like a win-win situation (in a closed system; no time to discuss external competitors). When tax payments are squeezing profits from these instruments such that the marginal cost of origination and risk-assumption outweigh the tax-effected profits, we should get a lower level of risk. BUT when banks decide that, hey, this fancy new idea we’ve come up with is absolutely so profitable that even post-tax, its still a great idea, we’ll have something in the kitty to plug the hole if they screw up. And if they don’t, maybe that’s Obama’s next 10 years of healthcare funding right there.

All of this is, of course, a superficial application of Econ 1, so it’s not going to be perfect analysis. Here’s the other main challenge: How do we know what an “exotic instrument” is?

The problem with simply saying that we’ll let rational actors decide whether or not something is profitable, is that the externality blade cuts both ways. An overly broad definition of “exotic” would, in the short-run, reduce the level of beneficial innovation as well. Yet a too-narrow definition of such would be equally useless, bogged down by endless petitions and searching for loopholes. One compromise might be to capitalize off our existing infrastructure.

We already have a mechanism in place for evaluating the risk of securities on a periodic basis: Our much maligned notables, the ratings agencies. A tax could be applied based on the ratings that securities receive, with higher supply-side taxes on more risky securities. So let’s take a real life example at look at the securitization of California’s IOUs. The first time a securitization like that is performed, ratings agency A will assess the relevant factors, including a projection X years out, and rate the security. Proceeds from that will be taxed at a proportional rate. However, let’s say New Hampshire likes the idea and decides to try the same trick. Assuming that 1) new information has come to light or 2) the increase in securitized IOUs somehow makes EVERYTHING more risky, all the outstanding IOU-backed securities get downgraded, but only NH-issues get taxed since California already paid their dues. “Good” innovation, in the long-run, will become cheaper to issue, and “bad” innovation will become more expensive.

The nub of this is that it comes back down to the ratings agencies, which have, to put it mildly, not done a great job. The second piece of the plan might be to set up a government-sponsored ratings agency, which would remove all the incentive problems associated with agencies and the banks they rate, and also incentivize them to clean up their act. It’s hard to see how independent raters could stay in business if they had to compete with a government agency and the immense legitimacy it would possess. It also gives the government a great degree of control over the growth of the financial sector, which is going to be absolutely wonderful or stupid as hell, depending on the size of your paycheck.

I like the idea of a ratings-based tax because it straddles the middle ground between free choice and paternalism. Under the current system, we try to control demand by disseminating information on securities and letting consumers make their own choices. However, markets are imperfect, people are irrational, and greed always wins. Banks are simply do not have to pay enough for their crappy securities. Which is why we’re suddenly seeing such an active market in high-yields, despite investors having been kicked in the ass a few months ago. Conversely, imposing a ban on securities is much too rigid and will be full of loopholes that smarty-pants bankers will exploit. Combining market forces with some state-directed supply control will fine tune financial markets and possibly provide some much needed revenue for all the people with restless leg syndrome we need to treat in the future.

The taxman cometh to solve our problems?

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