Osborne Should Think Again On His Bank Surcharge

Mark Roe is the David Berg Professor of Law at Harvard Law School. This post is based on an op-ed by Professor Roe and Michael Tröge that was published today in The Financial Times, which can be found here.

HSBC’s decision last week to keep its headquarters in London, after reports that it would leave the UK if the levy on bank liabilities were not lifted, will have been greeted with relief at the Treasury. However, there is good reason to think the Treasury got a bad deal, jeopardising financial safety for not very much in return.

In his Autumn Statement last year, Chancellor George Osborne promised to phase out the levy, offsetting this with an 8 per cent surcharge tax on bank profits. Taxing bank profits is popular with voters, even though it makes the financial system weaker. Because it makes bank equity more expensive and ending the levy makes debt cheaper, the surcharge will push British banks to use less safe equity and more risky debt.

Since the financial crisis of 2008-09, regulators have sought to make banks safer by increasing bank equity. A bank with substantial equity can absorb losses without seeking government assistance. A bank with less equity will either fail or need government assistance when it suffers a reversal. The 8 per cent surcharge will push British banks to seek less outside financing via equity and more via debt. This is the wrong way to go.

Academic studies show that banks in countries with levies on debt have built stronger balance sheets since 2010, adding equity, as a percentage of total assets, at a faster rate than banks in countries without the levy. So repealing the good tax on debt while at the same time adding the tax on equity will undermine the progress that has been made in prudential regulation.

A back-of-the-envelope extrapolation from those studies suggests that the reforms introduced in November will offer an incentive to banks to lower their equity from current levels by about 4 per cent (2.5 per cent from the bigger taxation on equity and 1.5 per cent from lowering the existing bank levy’s tax on debt). This would be a very large reduction in bank equity, which rarely rises above 10 per cent of total assets.

One might suppose that prudential regulation will take care of the problem but that would be naive. Smart and wily bankers and their lawyers will always find ways to sidestep prudential regulation if that would result in banks paying more in taxes.

There are, however, alternative ways to tax banks that would discourage risk and excessive debt. The Treasury’s bank tax increases should have been, and should still be, structured with the bigger regulatory picture in mind.

For example, Mr Osborne could have kept the bank levy but made it more effective. Any revenue coming from taxing a bank’s equity and profits could come just as well from taxing its debt and interest. The first undermines safety; the second promotes it. If lowering the tax take from banks was the Treasury’s aim, a far better way to achieve it would have been to cut the tax on equity—but instead it did the opposite.

Innovative taxation structures on the books in several European countries adapt corporate taxes so that the main chunk of revenue does not come from equity. This system, typically called an “allowance for corporate equity,” treats the cost of equity in the same way that it treats the cost of debt, instead of aiming the tax at equity alone. The chancellor would do Britain a favour by considering, with more input from the regulators, whether to replace the surcharge with a tax that did not depress equity and did not thereby undermine the regulatory effort.

Observing Britain from the other side of the Atlantic, I have long envied its legal and regulatory environment. The UK has built and maintained one of the world’s leading financial centres, making it worthy of imitation. Fixing the bank tax, instead of succumbing to the politically driven impulse to add another surcharge on profits, would continue that admirable tradition.

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