Financial Activities Tax

The Financial Activities Tax (FAT) is a fiscal measure designed to impose taxation on the profits and remunerations of financial institutions, particularly targeting those activities that may contribute to excessive risk-taking or systemic instability within the financial sector. It is intended as a corrective and revenue-raising mechanism to ensure that the financial industry contributes fairly to public finances, especially in the wake of crises that often require government intervention.

Background and Concept

The idea of the Financial Activities Tax emerged prominently after the global financial crisis of 2007–2008, when governments around the world faced immense fiscal burdens due to the need to bail out failing financial institutions. Policymakers and economists argued that the financial sector should bear a portion of these costs, leading to proposals for new forms of taxation aimed specifically at banks and financial intermediaries.
The concept of the FAT was notably discussed in the International Monetary Fund’s (IMF) 2010 report, A Fair and Substantial Contribution by the Financial Sector, which recommended the introduction of two main taxes: a Financial Stability Contribution (FSC), based on the size and risk of financial institutions, and a Financial Activities Tax (FAT), levied on the sum of profits and remuneration. The latter sought to address distortions created by the under-taxation of the financial sector due to the exemption of financial services from value-added tax (VAT).

Structure and Design

The Financial Activities Tax is designed to apply to the profits and high levels of remuneration within financial institutions. The base of the tax typically includes:

• The sum of profits and wages of banks, insurance companies, and similar entities.
• Excessive bonuses or variable remuneration paid to employees, particularly those linked to risk-taking activities.
• In some models, only those profits and wages exceeding a benchmark rate of return are taxed, to target economic rents rather than normal returns.

Unlike VAT, which is difficult to apply to financial services due to the challenge of identifying taxable value-added, FAT functions as a proxy VAT by taxing the value-added created by financial institutions.

Objectives and Rationale

The FAT serves several interconnected policy objectives:

• Revenue Generation: To raise funds from a sector that benefited disproportionately from public support during crises.
• Corrective Incentive: To discourage excessive risk-taking, speculative activities, and inflated remuneration practices that may lead to instability.
• Level Playing Field: To correct the imbalance caused by the exemption of financial services from VAT, ensuring that the financial sector contributes proportionally to public revenues.
• Equity Considerations: To ensure fairness by taxing high-income earners and profitable institutions within the sector.

Comparison with Other Financial Sector Taxes

The FAT differs from other sector-specific taxes, such as:

• Financial Transaction Tax (FTT): A levy on individual financial trades, aiming to curb speculative trading.
• Bank Levy or Stability Contribution: A charge on the liabilities of banks to reflect the systemic risks they pose.

While the FTT targets specific market activities and the bank levy targets balance sheet risks, the FAT targets overall profitability and remuneration patterns. This makes it broader in scope but less distortionary to market liquidity.

Implementation Across Jurisdictions

Implementation of the Financial Activities Tax has varied across countries:

• Iceland introduced a FAT in 2011, taxing both profits and wages of financial institutions.
• Denmark and Norway have implemented similar mechanisms as part of their national fiscal systems.
• The European Commission and the IMF have both recommended its consideration as part of a coordinated global approach, though widespread adoption remains limited due to administrative and political challenges.

In the United Kingdom, although proposals for a FAT have been debated, the government has instead opted for a bank levy and a bank surcharge on corporation tax, both serving similar redistributive and corrective purposes.

Advantages and Economic Implications

The Financial Activities Tax offers several potential advantages:

• It provides a stable source of public revenue from a high-profit sector.
• It is administratively simpler to implement than transaction-based taxes.
• It can act as a disciplinary mechanism against risky compensation structures and speculative behaviour.
• By taxing the value-added of financial services, it may align the sector’s taxation with that of other industries.

However, critics note potential drawbacks:

• Risk of relocation: Financial institutions may shift operations to jurisdictions with lower or no FAT.
• Pass-through effects: Costs may be transferred to consumers through higher service fees or interest margins.
• Complexity in defining scope: Determining which entities and activities fall within the tax base can be challenging.
• Impact on competitiveness: Excessive taxation may reduce the global competitiveness of domestic financial centres.

Criticism and Challenges

Opponents of the FAT argue that it may unintentionally increase financial costs for end-users, discourage legitimate financial intermediation, and complicate regulatory compliance. Furthermore, without international coordination, the FAT could create incentives for tax arbitrage and uneven playing fields between countries.
There is also ongoing debate about whether FAT achieves its behavioural aims. Some studies suggest that the link between remuneration structures and risk-taking is complex, and taxation alone may not effectively curtail excessive financial risk.