February 10 NYU Tax Policy Colloquium (with Mick Keen), part 1

Yesterday, Michael (Mick) Keen of the International Monetary Fund appeared at our colloquium to present his paper, The Taxation and Regulation of Financial Institutions.

An initial word about my blogging about these sessions may be in order. IMF staff and officials, along with others who sometimes appear at the colloquium either as speakers or in the audience, sometimes have to be mindful of what they are quoted publicly as having said. Our colloquium discussions are private and off the record, a point that attendees from the press know and have honored. But it occurred to me a couple of years ago that my blogging these sessions was potentially inconsistent with this. Accordingly, for the last couple of years, I've had a consistent rule of commenting, not on what was said at a given session, but instead exclusively on my thoughts (both going in and once it was all over) concerning the paper and/or the topic.

The paper is a very interesting one, on an important and very difficult topic. The 2008 financial crisis highlighted huge problems in the financial sector. At a minimum, we were brutally reminded of two important negative externalities that may arise when financial firms fail. The first is the "failure externality." The collapse of institutions such as Lehman, AIG, etcetera can trigger severe and lasting recessions, initially because they trigger a collapse of the liquidity based on the transaction services they offer that a modern economy needs to function. The second is the "bailout externality." Because the consequences of banks' and quasi-banks' collapse can be so dire, the government (and hence taxpayers) often lay out substantial cash to restore their solvency, whether via FDIC-style advance guarantees or the implicit ones that triggered government action in 2008.

Since these are externalities from the standpoint of the managers and employees at a financial institution who are making business choices, it would be analytically useful to deploy the modern economic understanding of externalities as it has been developed in more straightforward settings - for example, with respect to pollution, which can be handled through Pigovian taxes, among other means. The idea would be to give these people more socially appropriate incentives or behavioral constraints.

Once one analogizes the harm banks can do to others to more familiar problems, such as pollution, one runs into the classic choice between Pigovian taxes and regulation. A tax sets a price, e.g., you can pollute as much as you like, but you have to pay $X per unitn of carbon or smoke or gunk. If the price is set correctly, economic production that generates gunk should only take place in cases where the benefit exceeds the cost, as now correctly measured by prices.

Or alternatively, you can regulate how much gunk can be produced and in what circumstances. While this may sound like the more big-government, anti-market approach (and in a sense it is), business often actually prefers it. The reason being that they get to earn rents by cutting the quantity produced, which is better for them (though worse for everyone else) than their having to pay a tax equal to the harm caused.

An intermediate approach is to use permits, as in cap and trade. Where the amount issued is fixed (as distinct from the case where the government will issue more if the price goes up), they resemble regulation by fixing the quantity of permitted pollution, but they resemble pollution taxes in letting the market decide (presumably based on cost differences) who will end up doing the polluting production.

In today's intellectual environment, market-based approaches have much more prestige than they did decades ago, reflecting their advantages, when private incentives are properly aligned, in handling asymmetric information issues along with the problem of what incentives government actors will have. But of course even a Pigovian tax is non-market-based in one sense: the government determines the price. (Hence it might be better still, as Coase argued, simply to assign property rights to one side or the other where transaction costs are low enough for this approach to work.)

This point notwithstanding, setting the price may nonetheless sound more appealing than fixing the quantity from a generally pro-market perspective. But Martin Weitzman, in his famous 1974 paper, Prices vs. Quantities, demonstrated that this is not generally true. With perfect information, the government can set either prices or quantities and get the same answer either way. And in the more realistic setting of limited information, which one is better depends on the broader circumstances.

Okay, enough very general background, as the question raised by Keen's paper is how one should deploy Weitzman's insights (and other relevant aspects of current knowledge) to think about the taxes versus regulation choice with respect to banks and other financial institutions. But as this post is already quite long, I'll post it as is and continue the discussion in a follow-up post.

(Link to part two is here, and link to part 3 is here.)