Saturday, January 3, 2009

Tax the culprits?

The shadow financial system has come to symbolize all that is wrong with gun-ho profit-seeking at the expense of society. Its implosion has affected the real economy after credit markets dried up, investors flocked to safer grounds such as U.S. Treasury bills, companies began hoarding cash and consumers clinched their wallets ever tighter. With the world economy being interconnected as it is, the problems are compounding in the form of a global recession.

However, there is nothing like crisis to stimulate creative thinking. Mark Foley proposes a tax on credit default swaps to generate revenue for the government in bad economic times.

As he puts it:

There would be several advantages to taxing the financial derivatives market in general and the credit default swaps market in particular:

  1. The U.S. government would have a new source of revenue which would not come from the “real” economy. This is capital that is tied up in speculative instruments, so taxing it would be unlikely to affect the “real” economy, except positively.
  2. The people who bought (or buy) credit default swaps to insure their actual risks would not be taxed, as they would exchange one asset for another at the same value. This would preserve the product for a legitimate purpose. This would also take some pressure off obligors because the number of players who would be willing to bet against a company (buy credit insurance against default) for only a small gain would be reduced, allowing the companies' creditworthiness to be determined by more normal market forces, such as suppliers and banks rather than financial speculators. Corporate bond yields might narrow as people try to purchase the outstanding paper for less than the cost of the tax if they really believe a default is in the offing.
  3. If a seller of credit default insurance was “too big to fail” or, as in the case of Bear Stearns, too interconnected to fail because of its credit default swap obligations, the government would obtain a vast amount of the resources for the rescue from the tax on the winners – rescues based on such payments would be a lot cheaper for the taxpayer.
  4. If the losing institution was not “too big to fail,” the taxes would be simply net revenue for the government to use for stimulus or to reduce its own deficit.
  5. It would essentially cut back the unknown taxpayer exposure to the rest of AIG's credit default swap book as well as those in the as yet un-rescued companies and some of the banks.

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