Will higher taxes on financial firms fuel another crisis?

Policy makers in the UK and Europe are contemplating higher taxes on financial firms anticipating that it will curb the kind of reckless financial creativity which is now widely recognised as one of the root causes of the recent crisis. The bankers’ prolonged over optimism not only triggered the crisis but now also has the whole population reeling under the austerity measures. An unfair situation? Hmmm...  yes, according to many. But if this is the general belief then the representative of the people, our Gov., has to do something about it. The world should be made fair at least the population should feel so. Why should the bankers’ responsible for all the crisis get away with so little punishment and again get back to the hay days of high bonuses while the unemployment level still remains too high for comfort? A fair and popular decision should entail greater punishment for the bankers. The poor, the homeless, the jobless, the middle class working hard to make ends meet must not bear the brunt of the crisis. It should be the responsibility of the bankers who are responsible for the situation. I think the Gov. is doing just that. Higher taxes on financial firms. Sounds fair, makes the junta feel happy and vindicated.

So far so good. However, is this really a solution or just a popular step to please the voters? Or should I say it’s another popular step of a popular government to remain popular?

I am concerned about the effect of this decision on the banking industry. What happens when your cost increases? You invest in more profitable projects to survive. What happens when your cost of capital increases? Many projects which you could have undertaken earlier no longer impress you as you look for higher returns to counter your increased costs. Can we expect the same to happen in the financial industry? Will they focus on still higher returns to remain profitable to counter the effects of higher costs through taxes? I believe they will. But do we not believe in high risk high gain investments? Can we safely assume this policy to apply in majority of cases where chasing higher returns can result in higher risk taking? Let’s not be too optimistic thinking that there will be a sudden rise in low risk high gain projects which will counter the weight of higher taxes and keep the financial firms as profitable! Also, as Adam Smith said “If profits above a normal rate of return exist in any sector of the economy, other firms will enter these industries and force down returns at which no excess profits exist.” And well if we agree that higher gains often attract greater risks then aren’t we pushing financial firms towards greater risk taking, greater financial creativity and a greater chance of triggering another financial bubble? One counter argument could be that the financial firms would settle for lower profitability and would not chase high profit projects or would not create opportunities for higher profits. But do you really expect that to happen? Won’t the competitive market push for greater profits? I think they would. So is this another decision focussed on gaining popularity rather than a long term solution? I think it is. But thanks to democracy, popular decisions will keep defeating correct decisions.