Thoma and Taxes

This post is a response to Mark Thoma’s article in the Financial Times yesterday, found here.

In his article, Thoma suggests that a Pigovian tax should be imposed on the financial industry to correct for the negative externality it generates (the negative externality being too much risk).

Two questions come to mind after reading Thoma’s article.

Will this tax decrease the amount of risk in the financial industry? My gut reaction is that a tax will not change the fact that many people in the financial sector are risk-takers. Taxing the bad behavior of Wall Street will not change the composition of its workers, who will continue to take speculative risks. In fact, if the tax is too high—and it would be if banks had to pay $6-$14 trillion as Thoma suggests—volatility of financial markets could increase if firms fight fire with fire and increase their risks given the higher taxes. Historical evidence (pdf) suggests that high financial transaction taxes is associated with higher risk taking and increased volatility.

Will this tax help the people it is intended to help? Given higher taxes, financial firms might increase their rates or the fees they charge to their customers. Long-term investments (such as buying a house) usually have a high price elasticity of demand, so imposing a tax on financial firms could lead to poor outcomes for the people Thoma claims the tax should help: those in the middle-class who were hurt in the Great Recession.

small percent changes in mortgages lead to large percent changes in number of houses bought (demand elastic)
Demand for houses is elastic

The fact that people tend to wait until the “market is right” to buy a house implies that a small percentage increase in price of mortgages will lead to a large percentage decrease in the amount of homes purchased. This might be a bad thing if a place thinks people ought to buy homes instead of rent them.

I agree with Thoma that mitigating risk in the financial sector is important and that Wall Street should be held more accountable for what happened in the lead-up to the financial crisis, but an FTT is probably not the best way to achieve this goal.

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