Taxing Systemic Risk

Abstract

A tax on the harmful elements of finance — a tax on systemic risk — would raise revenue and also lower the likelihood of future crisis. Financial institutions, which pay the tax, would try to minimize its cost by lowering their systemic risk. In theory, a tax on systemic risk is perfect policy. In practice, however, this perfect policy is unattainable. Tax laws need clear definitions to be administrable. Our current understanding of systemic risk is too abstract and too metaphorical to serve as a target for taxation.

Despite the absence of a clear definition of systemic risk, academics and policy makers continue to propose special taxes on finance. The most prominent proposal is the financial transaction tax (FTT), which has some possibility of being adopted in the European Union. The FTT and other similar proposals levy their taxes on proxies for systemic risk (for example, the volume of financial transactions or the size of financial institutions). While these proposals would raise revenue, they would fail as regulatory measures (and could even be counterproductive). While transaction volume and institutional size might be correlated with systemic risk, they are not causes of systemic risk. By exploring each of these issues in depth, this article provides a useful starting point for the discussion on taxing the financial sector.

Keywords: systemic risk, pigouvian