IMF - an interim report to G-20

A draft of the interim report by the International Monetary Fund to the G-20 countries is now available on the BBC website. We have copied the full text of the executive summary below, but draw your attention to two particular themes of close interest to TJN.

First, the report draws attention to the economic distortions arising from the special tax treatment given to loan capital. The tax deductibility of interest payments encourages heavy reliance on loan capital in preference to equity capital. To all intents and purposes this creates a situation in which tax payers are subsidising corporate investment. A previous report on this subject - Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy - raised the same issue in June 2009, suggesting that the solution might be to cut taxes on equity capital. The current report takes the same route:

Actions are also needed to reduce current tax distortions that run counter to regulatory and stability objectives. The pervasive tax bias in favor of debt finance (through the deductibility of interest but not the return to equity under most tax regimes) could be addressed by a range of reforms, as some countries already have done. Aggressive tax planning in the financial sector could be addressed more firmly.

We also share the concern about the economic bias arising from the different treatment of the two forms of capital, but the solution lies with removing the favourable treatment given to loan capital. Why should capitalist risk-taking be subsidised in this way, especially when it encourages aggressive tax avoidance? And the end-note reference to tackling tax avoidance needs amplification: too much effort is expended on this wasteful and harmful activity.

In addition to the much-flagged proposal for a Financial Stability Contribution, which will be evolved into a risk-based levy on transactions to provide contingency funding in the likely event of future financial crisis, the IMF report also proposes a new tax - a Financial Activities Tax - that will be levied on profits and remuneration:

Any further contribution from the financial sector that is desired should be raised by a “Financial Activities Tax” (FAT) levied on the sum of the profits and remuneration of financial institutions, and paid to general revenue.

We are strongly in favour of taxing banks. Too much of their profitability is based on what Britain's Lord Turner has described as "socially useless" activity. We'd go further: too many banks have turned tax evasion into a global profit centre. New mechanisms for taxing banks are entirely welcome.

The text of the IMF executive summary is given below. The full report is here.

A FAIR AND SUBSTANTIAL CONTRIBUTION BY THE FINANCIAL SECTOR

INTERIM REPORT FOR THE G-20

Prepared by the Staff of the International Monetary Fund

EXECUTIVE SUMMARY

This is an interim response to the request of the G-20 leaders for the IMF to: “...prepare a report for our next meeting [June 2010] with regard to the range of options countries have adopted or are considering as to how the financial sector could make a fair and substantial contribution toward paying for any burden associated with government interventions to repair the banking system.”

While the net fiscal cost of government interventions in support of the financial system may prove relatively modest, this greatly understates the fiscal exposures during the crisis. Net of amounts recovered so far, the fiscal cost of direct support has averaged 2.7 percent of GDP for advanced G-20 countries. In those most affected, however, unrecovered costs are on the order of 4–5 percent of GDP. Amounts pledged, including guarantees and other contingent liabilities, averaged 25 percent of GDP during the crisis.

Furthermore, reflecting to a large extent the effect of the crisis, government debt in advanced G-20 countries is projected to rise by almost 40 percentage points of GDP during 2008–2015.

Many proposals have been put forward to recover the cost of direct fiscal support—some of which have been implemented. Proposals for the government to recover these costs include levies related to selected financial sector claims and taxes on bonuses and specific financial transactions. The least distortionary way to recover the fiscal costs of direct support would be by a ‘backward-looking’ charge, such as one based on historical balance sheet variables. This would define a fixed monetary amount that each institution would owe, to be paid over some specified period and subject to rules limiting the impact on net earnings.

The focus of countries’ attention is now shifting to measures to reduce and address the fiscal costs of future financial failures, both through regulatory changes and through imposing levies and taxes on financial institutions. Measures related to levies and taxes should: ensure that the financial sector meets the direct fiscal cost of any future support; make failures less likely and less damaging, most importantly by facilitating an effective resolution scheme; address any existing tax distortions at odds with financial stability concerns; be easy to implement, including in the degree of international coordination required; and, to the extent desired, require an additional fiscal contribution from the financial sector in recognition of the fact that the costs to countries of crises exceed the fiscal cost of direct support. A package of measures may be needed to attain these objectives.

Measures that impose new costs on financial institutions will need to reflect and be coordinated with regulatory changes under consideration. This is critical for ensuring policy coherence, enabling market participants to plan accordingly, and avoiding adverse effects on economic growth from placing an excessive burden on the financial sector.

After analyzing various options, this interim report proposes two forms of contribution from the financial sector, serving distinct purposes:

- A “Financial Stability Contribution” (FSC) linked to a credible and effective resolution mechanism. The main component of the FSC would be a levy to pay for the fiscal cost of any future government support to the sector. This component could either accumulate in a fund to facilitate the resolution of weak institutions or be paid into general revenue. The FSC would be paid by all financial institutions, with the levy rate initially flat, but refined over time to reflect institutions’ riskiness and contributions to systemic risk—such as those related to size, interconnectedness and substitutability—and variations in overall risk over time.

- Any further contribution from the financial sector that is desired should be raised by a “Financial Activities Tax” (FAT) levied on the sum of the profits and remuneration of financial institutions, and paid to general revenue.

International cooperation would be beneficial, particularly in the context of crossborder financial institutions. Countries’ experiences in the recent crisis differ widely and so do their priorities as they emerge from it. But none is immune from the risk of a future—and inevitably global—financial crisis. Unilateral actions by governments risk being undermined by tax and regulatory arbitrage. Effective cooperation does not require full uniformity, but broad agreement on the principles, including the bases and minimum rates of the FSC and FAT. Cooperative actions would promote a level playing field, especially for closely integrated markets, and greatly facilitate the resolution of cross-border institutions when needed.

Actions are also needed to reduce current tax distortions that run counter to regulatory and stability objectives. The pervasive tax bias in favor of debt finance (through the deductibility of interest but not the return to equity under most tax regimes) could be addressed by a range of reforms, as some countries already have done. Aggressive tax planning in the financial sector could be addressed more firmly.

More analysis will be undertaken to assess and refine these initial proposals. The final set of proposed measures, including more details on key design elements, will be delivered to the G-20 leaders for their June 2010 summit. This work will be guided by the discussions at the April 2010 ministerial meeting, further consultations as well as the joint IMF/FSB/BCBS work on the cumulative quantitative impact of regulation and tax burdens on the financial sector.