Corrective Taxation, Leverage and Compensation in a Bloated Financial Sector

Abstract

The financial crisis of 2007-2009 reinvigorated academic and policymaking interest in the design of prudential regulatory regimes governing the financial sector as a policy instrument intended to moderate financial instability. The crisis also motivated interest in the role of taxation as a complement to these regimes. In practice, however, the use of tax instruments has been modest. This paper considers three tax instruments that could serve this complementary role. Political economy considerations aside, it is suggested that the use of bank leverage taxes as the tax instrument of choice is unsurprising. But as recognized in the literature, a corrective taxation case can be made for an increase in the rate of such taxes as an instrument to eliminate the availability of cheap debt for systemically important institutions. Although returns to risk taking is a potentially robust tax base, the weak behavioral properties of this tax instrument have apparently diminished its appeal for policymakers, while a revenue-raising imperative that might otherwise motivate its adoption is muted considerably by the adoption of a bank leverage tax. Perhaps somewhat surprisingly, the tax literature does not consider the case for an excise tax on bonus and performance-based compensation as an instrument to alter the structure of compensation. This may be attributable, in part at least, to redundancy where regulatory regimes can be used to impose constraints with similar intended effects.