Special Banking Taxes in Visegrad Countries: The Good, the Bad, and the Ugly

15. 3. 2017

Governments in Visegrad countries are balancing the interests of local electorates and foreign investors, which are less aligned than ever during the last decade. This increasingly nationalistic debate also covers special taxes on banks and other network industries that are largely under foreign ownership.

Taxing banks can be economically justified and politically popular, but it can also hurt voters and domestic companies more than bank shareholders, while also undermining the credibility of business environment. The Visegrad approach to bank taxes differs. Hungary, increasingly mimicked by Poland, pursues the riskiest strategy that includes not only excessive taxation, but also the return of state-control of banks. To date, Slovakia sticks to taxing, while Czechia misses out on this fiscal opportunity altogether. All four countries thus could benefit by aligning their approach with the European mainstream.

The Good Justification for Special Bank Tax

The economic case for special bank taxes relies on their capacity to mitigate failures of the banking market that undermine banks’ stability. If banks rely too much on volatile external funding, the special tax can induce them to attract more stable sources such as savings of retail clients. If excessive bonuses induce reckless focus on short-term profits, tax on bonuses can suppress it. If costly regulatory requirements protect incumbent banks from competition, while complex design of their financial products shelters them from otherwise ubiquitous value added tax, then special taxes can compensate for these unfair advantages. The economic theory would qualify such measures as “Pigouvian taxes” that remedy negative externalities.

Related category of well-justified bank taxes sets money apart for rainy days of crisis. Such taxes—that come under variety of labels including contributions to resolution funds or to deposit guarantee schemes—have increased dramatically during the post-crisis regulatory reforms and the development of EU’s banking union. Consequently, all EU member states hiked up these rates, but fifteen of them also maintained special bank taxes over and above the EU requirements. They justified these measures either by additional improvements in financial stability or the need to recoup public funds used for bank stabilization during the crisis.

However, subsidiaries of Western European banks in Czechia, Slovakia, and Poland did not need any public support as they carried on through the crisis with flying colors. Paradoxically, many of them were in better financial shape than their Western parents and their profitability often helped to stabilize parent groups by paying for losses from their misadventures in other Eastern and Southern European economies. Yet, this unexpected paradox provides another legitimate argument in favor of special bank taxes.

Sometimes banks, or any other firms, simply get lucky and accumulate extraordinary profits that cannot be justified by any innovation, strategy, or any other factor under their control. Inevitably, such occurrences attract public attention, including calls for windfall taxes. This factor was present in Visegrad countries, since the profitability of big banks over the last decade was rooted not only in well-designed strategy, but also in the structural transformation of these economies. Banks set their financial parameters prudently on the assumption that they do business in the volatile emerging market environment, yet they increasingly found themselves in economic circumstances that were comparable or in some years more stable than their Western European home economies. In such cases, various provisions and reserves for expected losses turn to unexpected increase in profits that can be send home through transfer pricing schemes and high dividends. Yet, the macroeconomic stability and structural transformation was an outcome of broad societal effort over the last quarter of a century, hence, calls for windfall taxes that allow public budgets to benefit from achieved stability do not seem unjustified.

At the same time, not all Visegrad banks avoided major mistakes. In retrospect, their worst blunder was to offer foreign currency loans to retail consumers, which shifted exchange rate risks entirely onto households that—unlike banks—cannot hedge and manage them. Hence, when the foreign currency (Swiss franc, euro, or Japanese yen) appreciate by 10 percent so do the monthly mortgage payments in forints or zloty. Many households in Hungary and Poland still struggle with these consequences and the issue remains the neuralgic point between foreignowned banks and governments. In contrast, Slovaks avoided the problem by the timely adoption of the euro, thus eliminating the exchange rate risk altogether, while Czechs viewed koruna as a stable currency with low-enough interest rate not to experiment with loans in other currencies. Hence, banks in Czechia and Slovakia avoided major losses largely due to policies of respective governments and central banks, which only strengthens the case for windfall taxes on the recent streak of exceptional bank profits in these countries.

While Slovakia imposed the special bank tax in 2010, Czechia did not, although the 2013 manifesto of the ruling social-democratic party noted such proposal. Czech governments thus miss out on the opportunity for windfall bank tax, even though this idea has truly cross-partisan pedigree and is not without precedent.

Margaret Thatcher’s conservative government was the first to introduce the windfall tax in 1981. It amounted to about 20% of banks’ annual profits and a year later it was imposed on North Sea oil and gas. The next practical application came with the New Labour government that imposed the tax on all privatized utilities after 1997. In the Czech Republic, a windfall tax was imposed on solar energy generation in 2012, when a combination of regulated prices and drastic decrease in the costs of solar technology created extraordinary profits.

The Bad Consequences of Special Bank Taxes

Even well-justified special taxes are prone to unintended consequences and thus need an intelligent attention of policy-makers so as not to outlast their purpose. Banks’ main argument against taxes is that they will have to reduce lending to the real economy and will become more vulnerable to economic shocks. In Visegrad countries retained profits are the primary source of bank capital, since foreign parents largely closed funding taps for their subsidiaries during the crisis. Therefore, taxing profits reduces the amount of credit that banks can provide without infringing regulatory requirements. However, this argument works only in cases when banks do not have enough capital and deposits. In Czechia and Slovakia, banks were excessively well capitalized and had more deposits than they were willing to turn to loans throughout the last decade. Hence, profit taxes would not alter their ability to offer credit.

Another problem is that banks can easily pass any tax increases onto the clients. They do not compete on the price of their products, but rather on their range and quality. This makes it easy to pay for additional taxes merely by increasing interest rates and fees on loans, mortgages, and other services. Indeed, some large-scale international comparisons suggest that on average only about 15 percent of any extra tax is borne by the bank owners, while the rest is passed onto clients.

Moreover, special bank taxes typically impact only selected assets or liabilities, which also triggers unintended consequences. If, for example, government bonds are excluded from the relevant tax base, banks are likely to purchase more of them. This may reduce the costs of government financing, but also decrease credits to the firms and increase the unhealthy link between stability of banks and domestic economies. Banks’ effort to reduce the tax base may also induce them to develop new riskier investment strategies, reengineer their balance sheets with less transparent financial instruments, or circumvent their local subsidiaries by cross-border lending from parent banking groups. In short, if special taxes are high and not well designed, they are likely to stimulate the kind of risky behavior that made banking sector excessively complex, difficult to regulate, and in the end more fragile before the 2008 crisis.

Given these risks, three criteria emerge as important design principles that limit unintended consequences. First, tax rates should be set at rates comparable to other relevant countries in order to avoid cross-border arbitrage. Second, some proportion of receipts should be allocated to making the banking sector more resilient. And third, special tax rates should impact all banks in uniform manner to avoid distortion of competition. Unfortunately, none of the three bank taxes in Visegrad countries meet these criteria very well.

When Hungary introduced its bank tax in 2010, it was the highest in the EU by far – a multiplication of comparable taxes in Sweden, Germany, Austria, or the UK. Slovakia introduced the tax in 2012 only to relegate Hungary into second place, and even when the Slovak rate was halved in 2015 it still remains the highest in the eurozone. The Polish tax introduced in February 2016 is also relatively high, albeit somewhat lower than the initial rates in Hungary and Slovakia. Moreover, all three countries use the tax receipts as the general fiscal income and do not allocate them for strengthening the resilience of the banking sector. This contrasts with most other EU countries, where only those that provided direct state aid to banks during the crisis use the bank tax to increase general fiscal revenue.

The Ugly Modalities of Special Bank Taxes

Nonetheless, the most controversial aspect of the bank tax design in Hungary and in Poland is their unequal impact on different types of banks. When the distinction is not justifiable by any measurable criteria such as a difference in banks’ risk profiles, it distorts the competition and it may also discriminate between foreign and domestic bank owners. While differentiation also exists in the German bank tax design, in Hungary and Poland the small-print of bank taxes imposes disproportionate tax burden on the foreign-owned banks, while shielding those under domestic ownership. The arrangement comes rather close to discrimination of foreign investors, which—as Polish government should learn from the Hungarian case—is a policy that backfires.

It is no coincidence that Hungarian economy is most constrained by poor availability of credit. Its foreign-owned banks are taxed heavily and were forced to convert foreign exchange loans to forint-denominated loans at a great loss. This only increased the non-calculable political risks stemming from erratic and non-transparent policy-making. Consequently, increased risks reduced both the willingness and ability of banks to provide credit for the economy, thus undermining investments, consumption, and the recovery of living standards. Declining credits, in turn, led to government’s attempt to bring large Hungarian banks back under national control by buying stakes privatized nearly twenty years ago. However, state involvement in banks raises again the prospect of political meddling into risk management and with it the return of “banking socialism” that plagued banks in Visegrad countries during the 1990s and which nearly toppled the Slovenian economy into a Greekstyle program as recently as 2012.

Overall, the bank taxes in Visegrad countries would benefit from better alignment with similar policies in the home countries of their banks. In case of Hungary, Slovakia, and Poland, this translates to lowering the tax rate and avoiding indirect discrimination of foreign-owned banks. In the Czech case, it means introducing reasonable bank tax while the unusual profits related to structural transformation of the economy last. Such an alignment allows Visegrad governments to strike the balance between voters’ interests that expect the foreign capital to contribute to public finances and foreign investors concerned about predictability and fairness of the business environment.

Zdeněk Kudrna

works at the Salzburg Centre of European Union Studies, University of Salzburg. His work recently appeared in Journal of Common Market Studies, Journal of European Public Policy, Journal of Banking Regulation, and in a volume on the EU‘s decision traps by Oxford University Press. He is a member of the Regulatory Impact Assessment Board of the Czech government and regular commentator on European affairs in the Czech and Slovak media.

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