Tax Analysts Blog

Should Tax Havens Pay for Bank Bailouts?

Posted on Sep 29, 2009

Cloudy, with a chance of meatballs. That's the current box-office hit out of Hollywood. It is also a good forecast for the future of bank regulation in the United States and around the world.

On Capitol Hill the intellectually daunting task of designing a shock-proof financial system has been dumbed down to two mini-debates. The first is about instituting more consumer protection in financial products. This should be a no-brainer for a country where I am constantly reminded that my child's inflatable ducky is "not a flotation device." Of course, economically illiterate lambs can use a little help of an even imperfect government when they buy vital and complex products from Wall Street wolves.

The second is about which agency should run the show. The Fed, as suggested by former Fed-Chairman Volcker? The Treasury, as suggested by World Bank president and former long-term senior Treasury official Robert Zoellick? A council of existing agencies, as suggested by Treasury? Or a new super agency, favored by Senate Banking Committee Chairman Christopher Dodd (seeking re-election and trying to look tough on banks)? Well, this is classic fighting of a turf war that is second nature to politicians. Unfortunately the issue of who will regulate is unimportant compared to the issue of what new regulatory policy will be.

The phantom turf battle is a distraction from the real issue about which most legislators don't have a clue: what actually should we do to prevent the next meltdown? What -- specifically -- should we do about capital requirements, bank pay, rating agencies, central clearing of credit derivatives, restricting proprietary trading by commercial banks, off-balance sheet subsidiaries, mortgage underwriting standards, differentiating between banks and other systemically risky financial institutions, and procedures for government resolution of the inevitable next collapse of a major finance house? And then how do we coordinate this with all three or four dozen countries hosting significant financial sectors so contagion does not spread across national borders and without harming international competitiveness of domestic companies?

Veterans of financial policy know that taxation of financial institutions play second fiddle to regulation of financial institutions. This is one bit of conventional wisdom that will likely survive the crisis. So given the hazy future of bank regulation what can we say about the future of bank taxation? With all the usual caveats about predictions, let me suggest that the best clues to the answer can be found in the current debate about how governments plan to unwind (or "resolve") failing financial institutions with operations in more than one country.

A few quick words of background. First, of course, everybody wants to focus on preventing another major bank failure so we don't need bailouts. But nobody is so ridiculous as to suggest failures and subsequent bailouts can be prevented. Given that there will be financial firm meltdowns, we want to resolve them in the least costly and disruptive manner. Libertarian leaning economists make a good point that failure helps enforce market discipline (by preventing moral hazard). Moreover, similar to the way a large standing army may prevent a war, orderly resolution procedures can reduce the fear that stokes bank runs and can help prevent a financial crisis from ever even beginning.

Second, almost any significant bank resolution will involve a bank with cross-border operations. Yet, the U.S. debate in stereotypical fashion treats international coordination as an afterthought when it is actually the central and most difficult issue.

The Europeans -- particularly the British -- are light years ahead of their U.S. counterparts on the issue of cross-border bank resolution. There are three general approaches. First, there is the idea of creating a supranational regulator -- something like an international FDIC -- to unwind failing international banks. This is a theoretical ideal, perhaps useful as a point of reference, that absolutely nobody considers politically feasible.

Second, there is international coordination by national bank resolution authorities. (This is sometimes called the "universal" approach.) This is probably the approach most preferred -- particularly by the banks themselves. Banks would continue their multinational sprawl. National regulators would retain authority but somehow align their policies with those of the rest of the world. The problem with this approach is that the practical hurdles appear insurmountable. National authorities are already having difficulty sorting out policies for even wholly domestic failures. Which institutions should be assisted? When does the regulator enter the picture? Should a "bridge bank" be used? Under what terms should a merger be encouraged? How should different stakeholders -- shareholders, bond holders, depositors -- be treated? And then when and how and how much should government funds be employed? These are huge issues in the domestic context. In the international sphere it is hard to see how an operational policy could be negotiated and enforced among national governments. The most promising approach to international coordination would be to allow the country where the headquarters of the bank resides (and presumably where the bank has the largest presence) to take the lead.

The third approach is ring-fencing of bank activities along national lines. (This is sometimes called the "territorial" approach.) This would require simplifying existing bank structures so it would be clear to authorities which businesses inside a holding company should be assisted in the event of a failure.

Now the big question that regulators and politicians avoid like the plague is this: after private-sector solutions have been exhausted, and it is agreed a bailout is necessary, how will governments allocate the cost of those bailouts? During the 2007-09 crisis most of the cross-border bailouts have been handled on an ad hoc basis. When the Dutch-Belgian bank giant Fortis needed a bailout, the governments of Belgium, Netherlands, and Luxembourg negotiated a division of costs roughly proportional to the size of the business in each country.

Even putting international politics aside, it is still difficult to see how these allocations should be made in the future. The universal approach -- with its emphasis on home country regulation -- suggests that the burden would be placed on the country where the bank has its headquarters. The territorial approach suggests that once business lines are drawn along national borders each government should only support the bailout of the business designated to be within its borders.

I will now make a simple assertion that, to my knowledge, has not been suggested anywhere else: the country that pays for the bailout in bad times should collect taxes from the bank in good times. I'm confident I could devise clever economic rationales for this claim, but for the time being let's just appeal to common sense and to the idea that once the smoke clears this is what the political system will demand.

If you accept my simple assertion, the universal approach suggests that home countries should collect more taxes. This is a new argument for strengthening worldwide taxation of large financial institutions. (Under worldwide taxation, the home country claims the right to tax the worldwide income of companies with headquarters in their borders.)

Alternatively (still assuming you accept the idea that the country doing the bailout should get the tax revenue), under the territorial approach to bank resolution, international banks would pay tax to national governments on national business. This approach would require massive simplification of existing corporate structures designed to maximize regulatory and tax arbitrage. Several commentators have acknowledged that these simplified structures would increase worldwide taxes because opaque subsidiaries lodged in tax havens would have to be eliminated.

So, both the universal and territorial approach spell trouble for the future of tax havens as sanctuaries for banks who like to shelter their profits from tax. If the universal approach is taken, why should home countries bear the brunt of responsibility and bailout costs for the advantage of tax havens that help reduce the fiscal resources of the home country and whose light regulatory regimes contribute to financial instability? If the territorial approach is taken, why should countries where the real business activities of banks are performed tolerate anything but the simplest structures? Simplicity means offshore subsidiaries will be the first to go.

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