When Regulation is Preferred to Taxation

Ever since the major economies of the world have been hit hard by the recent crisis and financial systemic risk emerged as a public menace, regulation and taxation of financial activities as a policy device to curtail systemic risk have been at the heart of policy discussions as well as on the headlines of academic debates. Donato Masciandaro (Department of Economics) and Francesco Passarelli (Università di Teramo), in Financial Systemic Risk: Taxation or Regulation? (Journal of Banking and Finance, Vol. 37, Issue 2, February 2013, Pages 587-596, doi: 10.1016/j.jbankfin.2012.09.020), feed into this debate from a politico-economic perspective. Modeling systemic risk as a pollution issue, under which free riding gives rise to excess risk, the authors show that taxation of financial transactions receives low support from the majority of small portfolio owners, whereas the same majority may strategically opt for regulation to shift a bigger portion of the cost of reducing systemic risk onto the minority.

Motivated by the observation that in the real world financial regulation is usually preferred over taxation despite their theoretical equivalence, the authors provide a mechanism within a general pollution problem to shed light on this conundrum. The authors model risk production by portfolio owners as a pollution production problem. In this economy, there are a majority of low-risk polluting portfolio owners and a minority of high-risk polluting portfolio owners. Regulation affects toxic instruments more than proportionally, which means that high-risk polluting portfolios endure a bigger impact from regulation. On the other hand, taxation has an impact on both high-risk portfolios and low-risk portfolios. As a result, the majority of low-risk polluting portfolios have an incentive to prefer regulation, since this way they can shift most of the externality reduction burden on to minority high-risk polluters.

The model predicts that a median risk producer above the average leads to a restrictive regulation level in this political game. This is because with regulation the externality of risk reduction largely hits the high-risk producers instead of low-risk producers, whereas with a tax low-risk producers equally share the costs.

The model's predictions have real life implications. Democratic societies of today populated with low-risk producing portfolio owners have a higher likelihood of opting for regulation instead of taxation. Therefore, this study sheds light on why we observe so much regulation rather than taxation in many countries hit by the recent financial crisis.