Tax Analysts Blog

How Should We Tax Wall Street?

Posted on Jun 29, 2009

An 80 percent tax on short term capital gains! Sounds like the liberals are taking over, doesn't it? But this radical proposal was not offered by Ralph Nader or It came from a former CEO of one of the nation's largest and most prestigious corporations. On June 25 Bloomberg reported that Louis Gerstner--who also headed the private-equity giant Carlyle Group--said short-term investment gains should be taxed at 80 percent as a way to put a lid on Wall Street's culture of greed. “If you buy something -- a stock or a bond -- in the morning, and you sell in the afternoon, the tax probably ought to be 80 percent,”said Gerstner.

The Gerstner proposal is not likely to find its way to the President's desk anytime soon but it forces us to think about an extremely tricky topic: the taxation of financial market risk.

You do not have to be a financial guru to understand the key issue. Let's take the example of homes constructed along a hurricane-prone coastline. When disaster strikes, compassion and politics require the federal government to generously aid the victims. But emergency government relief destroys the proper economic incentives. Families will be encouraged to continue in the risky behavior of building homes as close as possible to the seashore. Taxpayers' patience understandably will grow thin with these beach lovers. Especially, as is often the case on America's coastlines, because these homeowners are filthy rich.

One solution to the problem is to cut off all relief to victims of natural disasters. This is not a politically viable option. With the cameras rolling, America will not allow these victims to suffer. Another option is to regulate: thou shalt not build in areas unusually vulnerable to floods and storms. A third option is to require the purchase of insurance. This insurance could take the form of higher taxes that the government puts into a trust fund socked away to pay the costs of relieving victims of the inevitable disaster.

The financial crisis of 2008 is like a once in a lifetime catastrophic storm. It has retaught America the forgotten lessons of the Great Depression. More and more economists are talking about the type of risk-taking that got us into this mess as an "externality"--meaning that the full costs of this behavior are not just born by the actors (i.e., Wall Street investors and investment houses) but also by the public as a whole. Here is economist Charles Wyplosz ©'s, description:

The prevention of crises in the banking system is more important than in the case of other industries because their costs to society are invariably enormous. The root cause of banking crises arises because the social cost of systemic financial collapse exceeds the private cost to the individual financial institutions. Effective regulation should provide incentives for financial institutions to internalize these externalities.

Before 2008, people may have shrugged this off as a theoretical fine point. Now that one third of the world's financial wealth has melted into thin air, it should be painfully obvious to all.

The textbook policy responses to externalities is to tax or regulate them. Right now we are at the beginning of a tremendous debate about the proper amount of financial regulation in the aftermath of the 2008 market crash. Of course there is the risk that the government could end up over-regulating, thereby hamstringing the competitiveness of the domestic financial sector and putting an unnecessary drag on long-term growth. My money says that overregulation will not be a problem. The financial lobbies and their supporters in Congress are too powerful and have too much at stake to be beaten down---especially as time erases the memories of 2008.

An alternative to regulation is taxation of the risk that got us into this mess. This can be done in a variety of ways. As suggested by Gerstner, we can tax short-term capital gains earned by investors. We could reduce tax incentives for leverage by redesigning our tax code's bias in favor of debt over equity financing. We could put excess profit taxes on financial companies. And we could more heavily tax ridiculously generous executive compensation schemes that promote risky behavior.

Now here is the really tricky part. We can't regulate or tax too heavily too soon because--in order to reduce taxpayers' need to shore up financial institutions--we need to attract private capital to the financial sector. Taxes and regulation will drive away private capital that will get government off the hook.

But our debt-laden federal government will soon need lots more revenue. Otherwise, as Robert Samuelson pointed out in his column today, the government itself may be the cause of the next financial crisis. ("What if the glut of bonds causes investors to lose faith?") It will be hard to explain to Joe Sixpack why Joe Pinstripes deserves a tax break and the rest of us don't. Even more important, the government needs to prevent another financial crisis simply because it may not be able to afford another one.

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