Should there be a windfall tax on banks?

Good morning from New Economy Brief.‍

Last week the Italian government announced a windfall tax on the country’s bank profits, before, rather chaotically, changing course and watering down the policy the next day, seemingly because of falling share prices of the banks.

This episode isn’t a wonderful advert for policy-making- but the question of whether bank profits should be taxed more highly is a serious one. Campaigners in the UK argue that banks are reaping windfall profits due to rising interest rates, and that taxing them could raise billions to support public services or cost of living support.

This week’s New Economy Brief examines why banks are making huge profits, and the case for taxing them.

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Banking the rewards. The fact that UK banks are making record profits is not contested, but the scale of these profits is eye-popping. According to think tank Positive Money, UK banks made record profits of £33bn in 2022, and are set to blow that figure out of the water in 2023. In the first half of 2023, the Big Four UK high street banks (Barclays, Lloyds, HSBC and NatWest) alone made pre-tax profits of over £28bn, an 80% increase from last year and 725% up on 2020.

• What is going on? There are a number of factors driving bank super-profits, but the crux of the story is the impact of rising interest rates. The Bank of England’s policy of sharply raising interest rates in response to inflation has boosted bank profitability in two crucial ways, one which has received some coverage, and one which has received a lot less.
• Failure of transmission. The first is the way in which banks pass on the impact of rising interest rates to their customers. Broadly speaking this happens through two mechanisms; raising the cost of borrowing (mainly the interest rates on mortgages) and raising the interest rate customers get on savings. Anyone who has been following the mortgage market will know that banks have been very quick to pass on interest rate rises to mortgages (although most existing mortgage holders will be shielded for a time by fixed rate deals). But they have allegedly been less assiduous at rewarding savers with higher interest rates. This delay in passing on the higher rates to savers boosts bank profitability, as banks will be charging higher rates on money they are lending out, without offering those same rates to those depositing money in the bank. This prompted the Financial Conduct Authority to issue a warning to banks last month that it will not tolerate this kind of practice, while Conservative Treasury Committee Chair Harriet Baldwin put it more bluntly: “It is difficult to avoid the conclusion that our biggest banks are taking advantage of their most loyal customers to increase profits and CEO pay”.
• Central bank reserves. Where the picture gets really complicated is when it comes to the issue of central bank reserves, and the messy interaction between monetary and fiscal policy. The story starts with the enormous programme of Quantitative Easing (QE) undertaken by the Bank of England since the financial crisis in order to support the economy when interest rates were at rock bottom. This involved the creation of new money in the form of central bank reserves, which were used to purchase government bonds through the Bank’s Asset Purchase Facility (APF). The reserves that were created are held by private banks, and remunerated by the Bank at the base rate. Given that the rate that the Bank was getting on the bonds it purchased was higher than the base rate, this meant the Bank made big profits, which were recycled back to the Treasury. But now that the base rate has risen substantially, the Bank is actually paying significantly more in interest on its reserves than it is receiving on the bonds it holds. The Treasury is on the hook for these higher interest payments, so in effect what we are seeing is direct transfer from the Treasury to private banks who are holding large amounts of central bank reserves.
• How much are we talking? It’s a lot. The Bank of England created nearly a trillion pounds of central bank reserves through QE. These have started to be unwound as the bonds mature through the Quantitative Tightening programme, but banks are still holding hundreds of billions in central bank reserves. Last year the New Economics Foundation estimated what the impact of rising rates would be on fiscal transfers to the banking sector. They found that over the OBR’s five-year forecast period,taking into account the QT programme, an average base rate of 4% would result in a transfer of £161bn from the Treasury to the banks. Given that the base rate is already over 5%, and expected to remain high for some time, this might be a reasonably likely scenario. Certainly we can expect the transfer from the Treasury to banks this year to be in the tens of billions as a result of higher interest on central bank reserves.

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So is this a windfall? Campaigners argue that, just as energy companies are benefiting from high global gas prices, banks are profiting from high interest rates despite not doing anything to ‘earn’ these profits in terms of productivity gains or being rewarded for risks that they have taken. The point about the central bank reserves is that they are risk-free for the banks, and now they are effectively being given a huge reward for holding them.

• Undermining policy. In fact, some of the ways in which the profit is being made is actively working against government policy. Not passing on interest rates to savers, for example, blunts the effectiveness of interest rates in reducing headline inflation. Similarly, at a time when public services are struggling and politicians are arguing that there is ‘no money left’, it is hard to justify huge income transfers from taxpayers to banks, simply because those banks are holding risk-free central bank reserves.

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To tax or not to tax. For some campaigners this is a slam dunk case. Positive Money, for example, is arguing that this is clearly the case of a windfall that should be taxed. They say the simplest way to do this would be to raise the Bank surcharge from 3% to 35% (the same as the energy windfall tax) and estimate this would raise around £20bn this year from the Big Four banks alone that could be spent on public services or cost of living support. This would still leave banks incredibly profitable by historical standards. The windfall tax idea has gained support from ex Bank of England Deputy Governor Sir Charlie Bean, who has argued that it could raise tens of billions of much-needed revenue for the exchequer.

• International precedent. The botched Italian windfall tax may not be a wonderful advert for the policy, but Italy is far from the only country to impose a windfall tax on banks. A host of European governments including Spain, the Czech Republic, Hungary and Lithuania have imposed such windfalls. The FT summarises how windfall taxes are being used across Europe in response to the cost of living crisis.
• The Lady was for taxing. The main historical parallel for such a such comes from an unlikely source. In 1981 Margaret Thatcher imposed a windfall tax on banks in very similar circumstances (having first levied one on the oil and gas sector). The justification was that: “they had made their large profits as a result of our policy of high interest rates, rather than because of increased efficiency or better service to the customer.”
• The case against. Opponents of a windfall tax have two central arguments. The first is that bank profits are not a windfall, that they are a natural result of raising interest rates, and that bank profits always fluctuate according to conditions in the economy. The second is that imposing such a windfall tax could have negative economic consequences, by lowering bank share prices (as happened in Italy), hitting investment, and causing instability in the sector. US think-tank the Tax Foundation has accused governments of “punitively targeting certain industries” and some have argued for tightening of regulations instead of taxes. On the instability point, Dan Neidle, from Tax Policy Associates, argued that the original Italian proposal was incredibly badly designed and communicated, and it was this, rather than the principle of a windfall tax, which spooked the markets (others would argue that policy should not be determined by what is best for the share price of banks).
• Longer term solutions. Finally, it is worth pointing out that a windfall tax will not solve the underlying issue of the unintended interaction between monetary and fiscal policy as a result of private banks holding central bank reserves. There is arguably no good policy reason why banks should be making huge profits from this, and the New Economics Foundation has argued that the UK should adopt a ‘tiered reserves’ policy where interest is only paid on a portion of reserves held by banks. Both the European Central Bank, and the Bank of Japan operate tiered reserve systems, and NEF argues that the UK should follow suit and stop this problem at source, saving billions and untangling the muddle of monetary and fiscal policy in the process.

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