Stealing a March on Financial Crises: the Scope for Applying Corrective Taxes and Fees towards the Financial Sector – why, what, how A Review of the Literature

Abstract

The recent financial crisis demonstrated that the actions of the participants in a close-to-unregulated financial system are the source of significant negative externalities both on the latter and on the rest of the economy. Judging by the dominant reaction by the vast majority of the theoreticians and practitioners of the economics profession — genuinely utter surprise and confusion — it is no surprise that regulation and supervision, built on what has been revealed as the subject s empirically untenable postulates, failed thoroughly. Therefore, if the post-crisis reform efforts are to be successful, there is urgent necessity of economists developing an understanding of how financial crises arise endogenously. This is especially so for ex-ante measures — the ones aimed at reducing the scope for the occurrence of financial crises — on which the current composition will focus. The recognition of this fact in the post-crisis literature has taken one form in (re)discovering or reassessing the merits of various theories not incorporated into the mainstream economic framework. Therefore the relevant insights of several such contributions have been presented. As externalities are a form of market failure, one way to address the use is to employ corrective (Pigouvian) taxation. In the post-crisis literature this approach has been recognized as a tool to implement macroprudential policy. Various aspects pertaining to financial sector externalities — their concrete realizations and impact, their measurement etc. — are presented. Then, attention is shifted on to the various issues surrounding the implementation in general of corrective taxes and fees to deal specifically with financial sector externalities, which have been identified in the literature. Lastly, the pros and cons, and issues pertaining to the implementation of the three broad types of Pigouvian taxes and fees discussed in the literature — FTTs, FATs, and levies on financial institutions liabilities — are presented. The general conclusion which emerges from the literature is that there is in general role for corrective taxes in the efforts to promote a socially beneficial financial sector, but further, mostly empirical, work is required before concrete applications can be considered.