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More events at NYU Law School

On Thursday at the Tax Policy Colloquium, Michael Devereux presented his paper, Taxation of Outbound Direct Investment. He, my co-convenor Mihir Desai, and I all agree that, if you think about tax policy going forward on a fresh start basis, exemption is the most rational system for outbound investment by resident corporations, reflecting (in Michael's and my way of thinking about it, more than Mihir's) the point that newly becoming a U.S. corporation for tax purposes verges on being an election. But I suggested that the "transition" issue - i.e., the existence of resident U.S. corporations that are more or less trapped, and that would get a windfall gain from enacting exemption without a compensatory (for the Treasury) transition levy, makes the policy choice more difficult, if one assumes that such a levy will not be imposed. This may be the next topic I write about in the area, since the extent to which these are transition issues is not well understood.

Then on Friday NYU Law School was the site for a really excellent and informative conference, Rethinking the Taxation of the Financial Sector, that brought together people with tax, regulatory, and accounting expertise concerning that sector. My own thought, not just from attending this conference but more generally, is that, bad though the legal and accounting systems for banks may be, the real blame for the financial crisis goes (to the extent any of these systems are at blame), to the system for assuring adequate regulatory capital, which (obviously) failed catastrophically. What to do going forward is a harder question than this backward looking point, but one interesting idea that I have heard about recently concerns an "excess profits" tax when banks earn a great deal relative to the measure of regulatory capital they are forced to keep on hand (they like to keep this amount as low as possible so they will have more free equity to play with). Excess profits for this purpose would be calculated before subtracting high executive compensation.

Excess profits taxes are rightly viewed with skepticism in the academic literature (in keeping with progressive rates generally when applied to business entities rather than to individuals). For example, I gather that the excess profits taxes that applied in the past to oil companies have few defenders today, even among those who agree that this sector should pay higher net taxes (i.e., get fewer tax preferences and other giveaways0. But, as applied to banks and other such entities, there's an interesting ground for treating extra-high returns on regulatory capital as evidence that something nefarious, in the 2008 sense, may be going on.

Why would a bank earn unusually high returns relative to admitted regulatory capital? Pre-2008, bank managers would have said it's because they're so incredibly talented. Masters of the Universe and all that exploded rubbish. Seen from a 2010 perspective, one can't really keep a straight face upon hearing that. Second possibility, they are just lucky. OK, if the normal return would be 5% but they take a chance and end up getting 7% rather than 3% the excess profits tax has perversely asymmetric consequences (if it applies to returns above 5%). It discourages risk-taking in a setting where the downside doesn't arouse concern. But perhaps this isn't the most realistic and relevant scenario.

Third possibility, they are low-balling regulatory capital, which ought to be a regulatory concern. Fourth possibility is a variant of #2, but much more pernicious. They are making bets that have a high return when they pay off because of a severe downside / tail. In other words, the high return is evidence of making risky bets that reflect the moral hazard problem ("heads I win, tails you lose" for the manager or firm, whether because he moves on after getting a big bonus, or the bank has limited liability and/or is too big to fail).

I don't know enough about the possible design of this excess profit tax on banks, or about the sector itself, to offer anything approaching an outright endorsement. But it is an intriguing idea despite the skepticism I might usually have about excess profits taxes.

Full post as published by Start Making Sense on February 06, 2010 (boomark / email).