Canada should tax bank debt, instead of bank equity

Liberal party’s proposal a step in wrong direction, though not dangerous

The Liberal party announced its plan to raise the corporate tax rate on large banks and insurance companies from 15 per cent to 18 per cent. Maybe the banks should pay more taxes; maybe not. But if banks need to be taxed more, this is not the right way to do it. It will incentivize them to take on more debt, creating unnecessary dangers if an economic crisis hits the Canadian banking system.

The reason is simple: A tax on profits hurts bank equity, while interest on bank debt is tax deductible. This makes bank equity more expensive and makes debt financing more attractive. In countries with high tax rates on profits, companies, including banks, have higher debt levels. And when countries raise corporate tax rates, companies use more debt and less equity to lower their tax bill.

This risk-raising effect is particularly relevant for banks. In countries where the tax on profit is low, banks keep equity well above the regulatory minimum, but not in countries where the tax on profit is high. But equity can absorb losses if the banking system is hit hard by an economic downturn. Debt cannot and when banks cannot pay their debts, there are bailouts or cutbacks on lending just when an economy needs it most.

Canada was the only G7 country to avoid a serious crunch in the 2009 worldwide financial crisis. In 2007, as the financial crisis began, the Canadian government committed to reduce tax rates to 15 per cent; one of the lowest levels in the world. This was one reason (regulation is another) why large financial institutions in Canada were better prepared for the crisis than their American or European counterparts.

While the proposed three per cent increase in the corporate tax is not big enough to dangerously damage Canadian banking stability, it is a step in the wrong direction. This does not mean that banks should not contribute more to the COVID reconstruction effort — we offer no opinion on that — but there are safer ways to tax banks more.

After the last financial crisis, many European governments increased taxes on banks. They did not raise the corporate income tax rate, but imposed “bank levies.” The bank levy idea is simple: Regulators want banks to use less debt, hence, tax policy should make debt and not equity more expensive when the banks are taxed. In most countries using bank levies, the levies were calculated as a small percentage of the bank’s overall debt.

Some levies had particularly risky debt taxed more than stable long-term debt, which regulators wanted to encourage. Given that banks have so much more debt than equity to begin with, a very small tax on debt can raise the same amount for the government as a large tax on corporate profits.

For the Royal Bank of Canada, with core equity of 4.8 per cent of total assets and a 18 per cent return on equity, a levy on its debt of 0.03 per cent (or three ten-thousandth of the level of its debt), will raise the same amount for the tax authorities as the proposed three per cent tax on its profits. What’s more, that kind of a levy will push the bank to hold a little more equity, making it a little more stable.

Taxing bank debt rather than taxing bank equity makes sense from another perspective. Large banks benefit from an implicit government guarantee, because letting them fail in a crisis would be politically impossible and likely economically unwise.

However, this too-big-to-fail guarantee makes bank-issued debt safer to those buying the debt, and that makes bank debt a little less expensive for the issuing bank. This effect further encourages the banks to use debt, not equity. A levy on bank debt would be a shadow price that bank creditors pay for this guarantee.

Bank levies work: Empirical studies have shown that banks react by substituting away from debt financing and toward more equity, which is just what policy-makers should want. After the COVID crisis, some European governments started to think again about these types of tools. For example, the Swedish government announced plans for a bank levy to help finance the COVID effort. The Canadian government should do the same.