Tax Policies to Improve the Stability of Financial Markets

Abstract

While tax policies did not cause the recent global financial crisis, they almost certainly contributed to key vulnerabilities in the international financial system. In this paper we review existing tax policies identifying a number of channels by which tax distortions increase an economy’s vulnerability to financial shocks. In particular, we highlight how current tax policies contribute to excessive leverage, reduced transparency and increased complexity due to unproductive financial innovation. Rather than improving financial stability, some recent tax proposals, such as a Tobin tax or other financial sector taxes and levies, may in fact add to the vulnerabilities of the financial sector.

We identify a number of policy reforms which would reduce the potential for financial shocks to become crises with severe consequences for individual well-being. These reforms include, reducing corporate debt biases (such as through an allowance for corporate equity), improving loss offset provisions, eliminating transaction based taxes and moving towards accrual based taxation. These reforms would significantly improve risk allocation in the economy, particularly by reducing the bias towards leverage, improving the price revelation of financial products and the stability of financial markets. Many of these issues were also outlined in the recent Australia’s Future Tax System review.