Argument: Bank tax counter-acts expansionary effect of bailout

Issue Report: 2010 US bank tax


“The Bank Tax.” Gregory Mankiw Blog. January 15, 2010: “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.”

“Whose bonuses are they?” New York Times Editorial. January 14, 2010: “for the sake of long-term financial stability, Congress should also pass President Obama’s proposed big bank fee — intended to recover, over 12 years, the $117 billion that the administration estimates it will spend on financial bailouts. That should discourage banks that are already too big from getting even bigger and posing a larger threat to the overall economy.”