Financial Systemic Risk: Taxation or Regulation?

Abstract

In this paper we describe systemic financial risk as a pollution issue. Free riding leads to excess risk production. This problem may be solved, at least partially, either with financial regulation or taxation. From a normative viewpoint taxation is superior in many respects. However, reality shows that financial regulation is more frequently adopted. In this paper we make a politico-economic argument. If the majority chooses a tax, then it is likely to be too low. If it chooses regulation it will possibly be too harsh. Moreover, a majority of low polluting portfolio owners may have a strategic incentive to use regulation rather than taxation in order to charge the minority a large share of the externality reduction.

Keywords: financial stability, systemic risk, financial transactions tax, financial regulation, political economy

JEL Classification: G01, G18, G28, H23, E61