Hugo Dixon

Move over, Robin Hood tax. Make way for the FAT tax and the hot money levy.

The European Union’s plan to put an impost on financial transactions, popularly known as a Robin Hood tax, is dying. That’s a good thing. The idea was taken up by the Occupy movement as well as luminaries such as Bill Gates. But it never made economic sense. Taxing transactions wouldn’t have dealt with any of the causes of the financial crisis such as too much leverage and excessive reliance on hot money. It would just have driven business offshore.

Britain has always opposed the tax, meaning it had no chance of being adopted by the EU as a whole. Now the Netherlands has come out against it, so it can’t even be applied across the whole euro zone. With Germany’s finance minister saying that the “smallest thinkable unit” for the tax is the euro zone, it is only a matter of time before the Robin Hood tax is buried.

EU finance ministers will discuss alternative ways of taxing finance later this week in Copenhagen. The guiding principles should be to rein in excess risk-taking and remove distortions that bias one form of economic activity over another. With these ideas in mind, there are three specific things Europe, and for that matter the rest of the world, should do.

First, countries should impose a “hot money” tax on banks. Such a levy would apply to a bank’s wholesale borrowing. Ideally, short-term wholesale money should face an especially high levy: excessive reliance on such easy-come-easy-go funding was a big reason why banks from Royal Bank of Scotland to Lehman Brothers came a cropper. A hot money tax would encourage banks to raise longer-term money or attract relatively stable retail deposits. It would also mean that, if governments did have to bail out banks in future, the industry would at least have paid towards its own rescue.

So far 11 of the 27 EU countries – including Germany, Britain and France – have imposed such a levy, according to KPMG. The rest should follow suit. So should the United States, which has been toying with what the Obama administration calls a Financial Crisis Responsibility Fee. Although nothing will happen before the presidential election, a hot money tax could be one of the ways America eventually brings down its deficit.

Second, countries should remove the tax system’s bias in favour of debt. In most places, companies can deduct interest payments from profit before paying corporation tax. This encourages firms to leverage themselves up to the gills. The whole economy, not just the banking sector, is affected. But lenders are doubly exposed. Not only do they have an incentive to pile on the leverage themselves; they periodically get exposed to over-indebted customers, especially real estate developers and leveraged buyout houses.

Third, financial services should no longer be exempt from value-added tax. VAT is a consumption tax which is applied at each stage in the chain of production. Companies add VAT to what they sell other firms, but get a credit for what they purchase. This means only the final customer ultimately pays the tax. But in the EU and other jurisdictions, banks are not covered. They neither apply VAT to the services they provide customers nor get a credit on the VAT they pay on their purchases.

This anomaly causes several distortions. Final customers are undercharged for financial services, meaning they consume too much of them. Business customers, by contrast, are overcharged as there is no VAT they can reclaim on what they pay banks. Meanwhile, lenders have an incentive to perform activities in-house which would be more efficiently done by other companies – because they can’t recover the VAT they pay to outsourcers.

The VAT exemption probably also loses governments money. No proper calculations have been done. But a tentative estimate for the UK puts the lost revenue at 10 billion pounds a year, according to last year’s Mirrlees Review.

Given all these problems, it might seem mad that financial services are exempt from VAT. But there is a reason. Banks don’t charge fees for most of their services. Instead, they make the bulk of their income from the spread between the interest they charge for loans and what they pay depositors. Dividing up this spread among specific customers so that VAT can be applied to every bill would be quite tricky.

There are broadly speaking two solutions. One is to work through the technical complexities. The other is to introduce a financial activity tax, known as a FAT tax. This is applied to a bank’s earnings and the compensation it pays employees on the theory that the sum of these is just value added by another name.

The FAT tax has potential populist appeal, not just because of its name. After all, in the current environment, who would object to taxing banker pay and bank profit? One wrinkle, though, would need to be ironed out before FAT was an ideal tax. Some way would have to be found of giving business consumers a FAT tax credit.

There’s no disguising the fact that it would be complicated to revamp the way that banks are taxed. But given the havoc they caused in the crisis, the fact that the sector is under-taxed and the way in which the current system distorts economic activity, it is well worth the effort. The near-death of the Robin Hood tax provides a golden opportunity to do so.

At a dinner in Madrid earlier this month, the main complaint about Mariano Rajoy was that the new prime minister was treating the electorate like children. Many of the guests, supporters of Rajoy’s Popular Party (PP), understood that Spain had to cut its fiscal deficit and restore its competitiveness. But they didn’t like the fact that the prime minister hadn’t been frank about his plans.

In advance of last November’s general election, Rajoy said he wouldn’t raise taxes, make it cheaper to fire people or cut the welfare state. But he has now done the first two. After this week’s election in Andalusia, Spain’s largest region, he is expected to do the last.

Rajoy’s camp doesn’t see any problem in failing to be upfront. It would have been foolish to talk too much about austerity in the general election campaign as that might have frightened the voters. For the same reason, it would be foolish to tell them about reforming the welfare state in advance of the Andalusia election.

In the long run, the failure to treat the population like adults could cause trouble. But in the short run, the strategy has paid off. The socialist party lost nearly 40 percent of its votes in the general election, not least because it had done a poor job in government. It is now expected to lose control of Andalusia, its last main bastion, according to an opinion poll by Metroscopia.

Rajoy has already used the absence of any serious opposition – even a general strike called for next week doesn’t pose much threat – to push through one batch of reforms. The most important is of the labour market. He has made it cheaper for companies to fire people and largely dismantled the nationwide system of collective bargaining. The net effect will be that wages, which rose rapidly during the early years of the single currency, will fall – so restoring Spain’s competitiveness.

Between end 1998 and end 2009, Spain’s unit labour costs rose 38 percent, compared to 23 percent for the euro zone as a whole. In the past two years, they have come down 4 percent. The latest labour reforms could cut wages another 5 percent this year, according to Fernando Fernandez, economics professor at Madrid’s IE Business School. If the trend continues for another year or so, Spain will no longer be out of kilter with its euro peers.

The other main reform – cleaning up toxic loans from banks’ balance sheets following the country’s real-estate bubble – has had more mixed reviews. The government has told the industry to take provisions and stash away capital to the tune of 50 billion euros. While the number sounds high, the detailed rules mean many banks won’t need to raise capital and some of the rest could have nearly two years to do so. The government itself has been reluctant to put any more of its own money into banks. So it is trying to push weak banks into the arms of stronger ones and fill any capital shortfalls with guarantees from an underfunded deposit insurance scheme rather than with real cash.

The litmus test of whether this financial jiggery-pokery works will be whether banks are able to borrow in the markets and are then willing to support economic recovery by lending to businesses and consumers. There are some positive signs: Santander last week issued 1 billion euros in five-year senior debt. But most of the industry is still relying on handouts from the European Central Bank.

Rajoy’s second blast of reforms will be about putting the public finances onto a sustainable basis. In 2011, the budget deficit hit 8.5 percent of gross domestic product. Spain last week reached a deal with its euro zone partners to cut it to 5.3 percent this year. Although this is not as severe as the 4.4 percent originally pledged, it will still constitute a severe squeeze. What’s more, the government remains committed to bring the deficit down to 3 percent next year.

The prime minister has already given some ideas about what he will do. Income taxes were raised and some spending cut in an emergency budget just before the New Year. Rajoy is also putting in place a straitjacket to control the borrowing of the country’s profligate regional governments. If he wins this week’s Andalusia election, he will be in an even better position to impose his will as the vast majority of the regions will then be under the PP’s control.

But more will be needed. The regions, which are responsible for education and healthcare, will probably be allowed to charge people for part of the cost. And Rajoy will have to cut the number of public-sector employees and increase taxes further in next week’s budget.

Economically, this is logical. The concern is that Rajoy’s failure to be frank with the electorate could increase its cynicism. The people already have little trust in politicians of all stripes. Witness last year’s indignado movement, when hundreds of thousands of protestors took to the streets to complain.

This won’t matter if the economy, which the government expects to shrink 1.7 percent this year, stabilises next year. But what if GDP keeps shrinking, unemployment (now 23 percent) continues rising and the deficit remains stubbornly high? Spain would face renewed bond market jitters and further pressure from its euro partners to cut its deficit. Rajoy would then have to sell another dose of austerity to voters that wouldn’t believe him. Having treated them like kids, they might even throw a tantrum.

Francois Hollande’s sins are more those of omission than commission. The headlines might suggest otherwise. The socialist challenger to Nicolas Sarkozy as France’s next president has promised to cut the pension age to 60, tax the rich at 75 percent, renegotiate Europe’s fiscal treaty and launch a war on bankers. But these pledges aren’t as bad as they look. The real problem is that Hollande, who has a strong lead in the opinion polls, isn’t addressing the need to reform the country’s welfare state.

Hollande is a moderate. Like Sarkozy, for example, he is promising to cut the budget deficit to 3 percent next year, from 5.8 percent as estimated by the European Commission in 2011. But he still had to throw the left some red meat in the election campaign, which runs until May. That’s not just to prevent votes drifting to Jean-Luc Mélenchon, the far-left candidate. It’s also to avoid being outflanked by Sarkozy’s own populist attacks on corporate fat cats and bankers.

Still, the precise pledges probably aren’t what they seem, as I discovered on a trip to Paris last month.

Look at pensions. Hollande has said he’ll cut the pension age from 62 to 60 – at a time when Germany and other countries are raising theirs to 65 or more. But the fine print is more nuanced. This lower retirement age will only apply to people who have worked 41.5 years – in other words, since the age of 18. Given that increasingly people start working later, less than 5 percent of the workforce is affected, according to UBS.

Or take the 75 percent tax rate on income above 1 million euros. If Hollande as president really instituted such a rate, he would drive most of France’s remaining big earners off shore. But within hours of advocating the measure, an advisor was saying off the record that it might last only a few years. By the time it comes to implementation, enough exceptions and loopholes could also have been introduced to reduce the measure’s real bite.

Much the same goes for Hollande’s promise to renegotiate the euro zone’s new fiscal compact treaty. He is, in many ways, right to criticise this mutual austerity pact, the brainchild of Germany’s Angela Merkel. The snag is that he has no chance of changing the chancellor’s mind. While Hollande could theoretically refuse to ratify the treaty, that would create a mega-crisis. As a strong pro-European, the socialist is unlikely to want that – especially since France has its own huge borrowing needs.

More likely, Hollande would seek to “complete” rather than “renegotiate” the pact by adding some wording about the importance of growth. There is a precedent. The stability pact in the original Maastricht Treaty was rechristened the Stability and Growth pact in 1997 after France’s incoming socialist prime minister, Lionel Jospin, kicked up a fuss.

Finally, consider Hollande’s war against bankers. His headline-grabbing promise – to separate “socially useful” finance from “speculative” activities – isn’t scaring French financiers. Partly this is because there is a global trend. The United States has the so-called Volcker Rule, which bans banks from proprietary trading. Britain has the even more extreme Vickers plan, which will force banks to put their retail operations into ring-fenced subsidiaries to protect them from infection by investment banking business.

The other reason French bankers aren’t too fussed is because the Hollande camp has been indicating that it prefers Volcker to Vickers. One only has to look at how long it is taking America to implement the Volcker rule to see how a French version could be diluted by the time it is implemented.

There is a risk that, caught in his campaign anti-capitalist rhetoric, Hollande might have no other choice than actually trying to implement some of these proposals to the letter. The more he insists that he wants “substantial” changes to the euro treaty, for example, the more difficult it will be for him to climb down once he is president.

Still, the problem is not so much what the presidential candidate is saying but what he isn’t saying. France has a generous welfare system that it has only been able to finance by racking up debts and imposing high taxes. Spending stood at 56.6 percent of GDP in 2011, 11 per cent more than in Germany, while taxes amounted to 50.8 percent of GDP, 6 percent more than its neighbour across the Rhine. The bloated state machine, where unions still rule, is resisting reform. Meanwhile, various rules and privileges prevent the labour market functioning efficiently or add to labour costs, notably the 35 hour week or the over-regulation of services. These high taxes and rigidities help explain why French annual growth averaged 0.6 percent less than Germany’s in the five years to 2011.

Other euro zone countries, such as Italy and Spain, are being forced by the crisis to reform. But France is not. Ten-year bond yields, at 2.9 percent, are admittedly 1.1 percentage points more than Germany’s, but that’s still a lot less than Italy’s and Spain’s levels of 4.8 percent and 5 percent respectively. To be fair, Sarkozy is now talking about supply-side measures such as cutting social security payroll taxes. But he wasted the opportunity to reform during the last five years and is unlikely to be given another chance. Hollande, meanwhile, isn’t even talking about such matters – and is keeping characteristically mum about how he will cut public spending.

This suggests two main scenarios for a Hollande presidency. One is that financial markets calm down, there is no reform and France wastes another five years. The other is that a new phase of the euro crisis erupts, forcing Hollande to embrace reform at last. But given his failure to prepare the French people for change, and their predilection for taking to the streets to protest at reductions in their privileges, this could be a rocky ride.

Bailout may not be a four-letter word. But many of the rescue operations mounted to save banks and governments in the past few years have been four-letter acronyms. Think of the TARP and TALF programmes that were used to bail out the U.S. banking system after Lehman Brothers went bust. Or the European Central Bank’s LTRO, the longer-term refinancing operation. This has involved lending European banks 1 trillion euros for three years at an extraordinarily low interest rate of 1 percent.

The markets and the banks have jumped for joy in response to all this liquidity being sprayed around. So have Italy and Spain, whose borrowing costs have dropped because their banks have been able to take cheap cash from the ECB and recycle it into their governments’ bonds — making a profit on the round trip. But as has been the case with other four-letter bailouts, the LTRO has come in for criticism — most of it a variation on the theme that the way to treat debt junkies isn’t to give them another heroin injection.

One problem is that European governments could now feel less pressure to reform their labour laws and do the other painful things that are needed to get their economies fit. Another is that banks may delay actions that are required to let them stand on their own two feet: such as rebuilding their capital buffers and raising their own longer-term funds on the markets.

As if this were not bad enough, undeserving banks will be able to make bumper profits on the back of the ECB’s cheap money and, potentially, route them into fat compensation packages — although two British banks, Barclays and HSBC, have said they won’t allow bonuses to be inflated in this way. Meanwhile, the ECB could incur losses if the commercial banks that have borrowed all this money can’t pay it back and the collateral they have pledged turns out to be insufficiently valuable. Oh, and don’t forget that this is just a three-year operation. There could be another crisis when the banks need to find 1 trillion euros to repay the ECB in 2015.

The charge sheet is a long one. But the LTRO was a necessary evil. Just think back to early December when panic was stalking the euro zone. Without some form of bailout, there would have been a severe credit crunch that would have dragged the economy into a deep recession rather than the mild one it now seems likely to suffer. Large countries such as Italy and Spain could also have easily been shut out of the markets, potentially leading to a break-up of the single currency.

The ECB faced a too-big-to-fail problem. If it didn’t bail out the system, it would be faced with catastrophe; if it did, it would reward foolish behaviour. One can argue with the details. Did the money, for example, really need to be so cheap? But the central bank made a rational choice. The priority now is to limit the bad side-effects.

Mario Draghi, the ECB president, has made a start by telling European Union leaders at their summit last week that the three-year cash injection would not be repeated, according to Reuters. He said it had merely bought the euro zone time and it was essential that structural reforms were pushed through.

Hopefully, such lectures will be sufficient to do the job. But countries rarely reform unless their backs are to the wall. Take Italy. Mario Monti has made a remarkable start pushing through pension changes and liberalising services since taking over from Silvio Berlusconi. But there is much left to do: freeing up the labour market, privatising assets, revamping public spending and fighting tax evasion. How easy will he find it to push all that through now that Italy’s 10-year borrowing costs are below 5 percent?

Similar points can be made about Spain, where Mariano Rajoy’s reform programme has only just begun. Meanwhile, France, which has so far largely escaped the crisis, will not be under pressure to address its deep-seated labour market and pension problems. Francois Hollande, the socialist who will probably be the country’s next president, certainly has no ideological desire to do so.

But won’t the new European fiscal treaty deal with the issue? Sadly not. The demand for fiscal austerity was, indeed, the quid pro quo for the ECB’s bailout. But it was the wrong sort of conditionality. Balancing budgets is not the same as structural reform. The only thing pushing Europe’s governments down the latter route is exhortation and the warning that there won’t be any more bailouts.

With the banks, more tools are available to mitigate the damage from the LTRO. After all, governments, the ECB and regulators can tell lenders what to do. The most important changes – requiring them to build stronger capital bases and rely less on short-term funding — are already under way. The key thing will be to resist lobbying to delay and dilute these rules.

But there is also a case for revisiting the industry’s lax tax regime, especially if compensation remains high. Politicians have given most of their attention to taxing financial transactions, the so-called Tobin tax. But a better alternative could be to introduce what is known as a financial activities tax or FAT tax. Most countries do not apply VAT to banking. FAT, which would tax profits and compensation, would do a similar job. A three-letter tax could be part of the answer to a four-letter bailout.