The taxman goes global

The G-20, comprising 85 percent of the global GDP, 80 percent of world trade, and two-thirds of the global population has become an important international economic forum.

Since the 2008 global economic crisis, it has been holding heads of state summits every six months. The declaration of last month’s Toronto summit explicitly states that it is their first summit as the “premier forum” for international economic cooperation. India, as a part of G-20, is conscious about its responsibility to contribute to improving global economic and financial governance.

The expectations from G-20 to steer the global economy are high, the task enormous but its authority weak. The G-20’s success will depend on its performance collectively, and on the extent of success with which members, such as India, manage their development and governance challenges. G-20 membership therefore does not confer any automatic influence to a country.

Global taxes
As the global nature of many of the economic and environmental challenges has become more apparent, there have predictably been proposals for global taxes to deal with global issues, particularly those arising out of 2008 global economic crisis, and to help manage impact of climate change. As a premier forum G-20 must consider various proposals for global taxes.

Three examples of such proposals are: a global tax on banks and financial institutions; tax on selected international financial transactions; and carbon taxes on use of energy to manage climate change. Let’s consider the first two as the G-20 has until now been more focused on financial sector and transactions taxes.

The main objectives of the taxes on financial institutions and transactions are: first, to recover the fiscal costs of bailing out banks during the crisis; second, to create a fund for similar future situations; and third, to limit volatility and speculative activities.

The G-20 had in 2009 asked the International Monetary Fund (IMF) to submit suggestions for the tax on financial institutions, and on financial transactions.

The IMF submitted its final report, entitled “A Fair and Substantial Contribution by the Financial Sector” in time for the Toronto summit.

Requirements for Global Taxes
Before discussing the IMF’s proposals, it may be useful to consider the key requirements for global taxes. Unless these are met, economic globalisation and consequent cross-border effects of climate change on the one hand, and national tax jurisdictions and policies on the other will continue constrain the ability to address global challenges.

A truly global tax would require agreement among at least major countries on the following aspects:

The object. Should financial institutions tax be levied only on banks or on all financial institutions?

The base. Should assets or liabilities of the banks be taxed, and if one of the two is chosen, should there be exclusions?

The collection mechanism. Which body should be given statutory powers to collect global taxes? Nations guard their tax policy sovereignty and are reluctant to cede such powers to international bodies, resulting in a formidable constraint on levying global taxes. The tax collecting agency must have sufficient powers of enforcement, which given uneven power of different nation states, would be difficult to effectively establish.

Revenue sharing. Revenue from truly global taxes is likely to be substantial. The IMF estimates that a one basis point global tax on stocks, bonds, and derivative transactions could raise $200 billion every year. However, agreement on sharing such large sums among countries; or among different uses will be difficult.

In all four areas, there are no technically superior choices which could command agreement among reasonable parties. Thus, tax on financial institutions could be levied either on their assets or on their liabilities, with each tax base having cogent arguments to justify the selection.  These could be fine-tuned to reflect systemic risks which they pose to the domestic and international financial system.

Efficiency, revenue, and equity considerations however may vary considerably among the tax bases, inevitably bringing domestic and international political considerations in the choices made. It is therefore not surprising that the G-20 members are divided on levying taxes on banks. The United States, Germany, Britain and France back this tax with varying degrees of enthusiasm. China, Canada, Australia, Brazil, and India have reservations. Moreover, while the European Union and some others have been inclined towards creating global taxes, rising powers such as China have opposed such taxes.

The IMF’s proposals
Perhaps recognizing the difficulties in reaching consensus on above requirements for global taxes, the IMF Report enumerates proposals made by individual countries. These include schemes for a levy on financial institutions to help pay for the fiscal costs of bailing them out by the respective governments. The proceeds are also used to create funds for better resolution of poorly managed financial institutions in these countries. The IMF’s report details significant differences among country proposals, and how differing political economies in these countries may affect final outcomes.

It also recommends a Financial Activities Tax (FAT) on “excess profits” or “economic rents”, again levied by the individual countries or regions. It argues that the FAT would not distort economic behavior since normal returns are not taxed.

Since the G-20 summit in Toronto, EU lawmakers have approved tough new rules on restricting bankers’ bonuses, to take effect towards end of 2010. As the US proposals are non-mandatory guidelines, there are concerns that regulatory arbitrage, whereby activities migrate to more lax or light regulatory regimes, may put EU banks and bankers at a disadvantage. It will be interesting to observe the final shape of the EU proposals.

The IMF report does not favor a Financial Transactions Tax (FTT), which can be effective only if levied on a global basis. It argues that FTT does not focus on core sources of financial instability which are institutions and their incentive structures, and not transactions; that it burdens consumers as they hedge financial risks; and is prone to avoidance through financial engineering.

While it does not stress the point, it would be difficult to get consensus among all major financial centres on the base and the rate of the FTT; and on sharing of the potentially large revenues. The IMF has indicated that it is working on a substantial detailed report on the FTT.

The IMF’s report therefore stresses the terms such as co-ordination and policy coherence, with mutual interest of countries in ensuring global financial stability and growth as primary motivations for co-operation. These, however, are weak bases for tax treatment of the financial sector, which is both politically and economically powerful.

The issues raised by the IMF’s report were therefore, predictably left for discussions at the next G-20 meeting to be held in Seoul this November. Even there, no progress on global taxes on financial institutions or on transactions is expected. There may however be greater consensus on non-tax related aspects of global financial architecture. South Korea has already indicated that it will include development issues, including emergency loans for developing countries in the Seoul agenda.

India’s role
Substantive progress in addressing India’s developmental, financial management and governance challenges is a pre-requisite for India to continue to be an influential member of G-20.

India is justified in having strong reservations about global taxes on financial institutions and transactions. However India’s activities become increasingly global, many factors will impinge on it, which must be managed with tight strategy, but flexible tactics. Thus, continuing challenges posed to financial stability by excessive short-term financial flows, particularly by institutions, such as government wealth funds, constituting “shadow banking system”, must be managed.

Agreement on more prudential regulation of financial actors and activities, and correcting tax advantages in favour of debt financing, are areas where there may be wider agreement among G-20, and India should support such measures. It however must continue the conservative monetary management being pursued by the Reserve Bank of India. At the same time, India must reassign the due importance to substantive fiscal consolidation, something that governments in New Delhi and in the states have failed to do in recent years.