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Why the bank levy is a good idea, not just a populist tax grab

Jessica Irvine

Good economic policies are not always popular. Dismantling tariff barriers, unwinding middle-class welfare and deregulating wage bargaining were all met with uproarious opposition.

So it is a nice thing, indeed, to see a policy proposal which is not only outrageously popular, but also makes good economic sense.

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Big bank budget battle

The head of the Australian Bankers' Association has slammed Scott Morrison for the "smash and grab" decision to tax big banks.

The bank chiefs have greeted the Turnbull government's proposed $1.5 billion a year big bank levy with the usual outrage, as is their duty to their shareholders. They are keen to mark the levy as the "Mining Tax 2.0" – a poorly constructed tax, announced with no prior consultation with industry and ultimately defeated by a vociferous public campaign.

The levy, insists industry, is a dangerous tax grab, a random act of big government madness designed to punish the profitable, raising regulatory risks and threatening jobs and growth in the economy. Don't buy it.

The bank levy is not the mining tax. Sure, on the face of things, there are similarities. But the mining tax proposed by the Rudd government suffered from significant design flaws, including making government in effect a joint venture partner with mining companies, sharing their spoils in the good times, but also leaving taxpayers on the hook when profits fell.

A more simple tax, along the lines of the Petroleum Resource Rent Tax, would have been a better policy for taxpayers and industry.

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This time it's different.

The proposed bank levy is administratively much simpler. Australia's biggest five banks will pay a 0.015 percentage point levy every three months on the total value of their borrowings, with some exclusions. Over a year, this will add up to a 0.06 percentage point levy, which is expected to raise $1.5 billion a year, in addition to the $11.5 billion a year the banks already pay as company tax.

On the face of it, it's a bit odd to tax someone on their debts. We don't tax households based on the size of their mortgages, but on the size of their income. So why design the levy this way?

Well, because unlike your mortgage, which if you go belly up is your own responsibility, the major bank's borrowings are essentially guaranteed by taxpayers.

Of course, banks make a business out of borrowing money and lending it out at a higher rate – pocketing the difference. Sometimes, it all goes awry. But banks are too systemically important to the financial system to let them fail.

During the global financial crisis, the government stepped in to guarantee the deposits and new borrowings of all banks, in return for a fee. All those debts have now expired. But the banks continue to benefit from the knowledge that the government will step in again, if things go bad.

The more credit worthy they are perceived as being, the cheaper they can borrow.

And taxpayers carry the can when it all goes wrong.

It's a recipe for disaster, what economists call "moral hazard" where there is no incentive for good behaviour because bad behaviour is rewarded too.

It's hard to estimate the size of the discount banks enjoy on their borrowing by virtue of the taxpayers effectively going guarantor on their loans.

In all likelihood, it is much higher than 0.06 percentage points – which is all the levy seeks to recoup.

In a sense, the levy is similar to lenders mortgage insurance, which home borrowers pay when they have a deposit of less than 20 per cent.

If anyone should get this, it should be the banks which have been charging home borrowers this insurance for decades.

The bank levy is a form of protection for taxpayers in case the banks get into trouble and need their support to keep going. It is obviously true that the levy increases the cost for banks.

Will they pass it on? Undoubtedly. 

It's a common misconception, but it is actually impossible to tax an inanimate object like a bank. Taxes must be paid by humans, be they employees, consumers or shareholders. Banks only really have three options to response to the higher tax.

The first is to try to maintain profits by cutting costs elsewhere in their business, like finding new efficiencies, not pursuing some projects for expansion (like expensive gambles on offshore expansion), or reducing their wages bill by cutting either wages or wages growth of bank employees.

They can also seek to increase the prices they charge to bank customers, by increasing fees and charges, cutting interest rates paid out on deposits or increasing interest rates charged on loans. The extent to which banks are able to increase their prices will depend on what the "elasticity" of demand for their products is. That's just a fancy way of saying how willing customers will be to walk away and do business with another bank.

History suggests the banks are quite good at passing on higher costs to consumers through higher prices, including all the times they raised interest rates above the Reserve Bank rate, or failed to pass on cuts in full.

But this new bank levy only applies to the big five banks.

In theory, smaller banks will have a price advantage to help them steal away customers from the big banks if they try to pass on too much of the tax to customers. In this way, the design of the tax is good for competition and should limit price increases for customers.

The third and final way for banks to react to the tax, if they can't cut costs or raise prices, is to take a profit hit. That hit will be borne by the owners of the banks – not the CEOs expressing their outrage on TV – but the million or so investors who own bank shares directly, and every single Australian worker who owns bank shares through their superannuation.

About a quarter of shares held in super are banking stocks – such is the weight of the banks in the Aussie sharemarket.

It is most likely that shareholders will suffer some hit. To the extent those with big super balances tend to be the well-off, that is less of a concern from a fairness perspective.

The truth is, banks have been a target for higher taxes for a long time. Their returns on equity are consistently higher than in most other advanced countries, at about 10 to 15 per cent. The timeworn investing mantra is the "higher the risk, the higher the return". But banks are too systemically important to fail. As an investment, they are low risk. Their returns should be low too.

Indeed, banks, being part of the plumbing of the financial system, should see returns that better match those of sharemarket listed utilities, which return around 5 per cent.

The bottom line is the Turnbull government has come up with a policy of genuine merit; one that will help fix the budget, while also boosting competition and reducing systemic risks in the banking system.

It's a policy with bipartisan support that should pass Parliament in a matter of weeks. How refreshing.

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