Throwing the baby out with the bathwater

Poland's new conservative government plans to launch expensive social welfare programs which are to be covered by additional taxes. WBJ Observer analyzes a new levy on banks and assesses the impact it may have on the economy By Wojciech Rylukowski The banking sector in Poland is one of the most profitable. We propose that banks share with society,” Law and Justice's (PiS) candidate for Prime Minister Beata Szydło said in parliament in July 2015 while presenting the party's program, of which a robust social spending agenda was a large part. In order to finance benefits for children, a higher personal tax threshold, and the lowering of the retirement age PiS proposed to levy new taxes on large retailers and banks. The latter was intended to bring in PLN 5 billion in revenue, roughly a third of the amount needed to cover the expenditure of the child benefit program. From Tobin to the IMF The idea of taxing financial institutions is not new. It wasfirst tabled by Nobel prize laureate James Tobin after the Breton Woods system ended in 1971. Since the US dollar was no longer pegged to gold and a new regime of volatile floating exchange rates had emerged, the economist proposed imposing a 0.1 percent rate tax on every currency exchange transaction in order to act as a disincentive to short-term currency speculation. The tax rate would be so small that it wouldn't hurt the real economy (trade) at the same time making speculative transactions unprofitable. “My proposal is to throw some sand in the wheels of our excessively efficient international market,” Tobin wrote in 1978. The idea wasn't picked up on immediately, but it would re-emerge every now and then, particularly after a financial crisis: the Mexican, the Asian or the Russian. The latest resurfacing of the notion was triggered by the 2008 global crisis. Two years after Lehman Brothers fell, the International Monetary Fund published a paper, in which it outlined the proposition of a contribution to be paid by financial institutions that would stabilize the system and cover the costs of potential economic breakdowns. The IMF suggested that the levy, called a “Financial Stability Contribution,” should be imposed on liabilities excluding equity and saving deposits. This way, only short-term speculative transactions would be taxed, while citizens' savings would remain untouched. The European Commission calculated that a tax rate of 0.15 percent would yield €50 billion for the EU 27. Some of the battered European countries, which had pumped up to five percent of their GDP directly into the financial system in the aftermath of the crisis, jumped at the idea eagerly. The Hungarian experience [caption id="attachment_94326" align="alignleft" width="300"] Image: shutterstock[/caption] Although the form of the levy differs from country to country as some of them have embraced it in the shape recommended by the IMF (Belgium), while others have taxed minimum equity requirement (France), or risk-weighted assets (Finland), the goals of these efforts were alike: firstly, to curb risky behavior and diminish the probability of future crises, and secondly, to raise the money needed to cover the costs of past or future crises. But, one country broke away from these shared goals. In 2010, Hungary imposed a banking tax for other reasons entirely: to plug the budget hole and keep the deficit at 3.8 percent of GDP, the level agreed with the IMF and EU in exchange for a credit line. Since the country was severely bruised by the crisis, with its economy shrinking by 7.5 percent just a year before, social attitudes towards punishing banks were favorable. “It is unacceptable, with common sense, to respect banks as sacred cows at a time when a global crisis that started from the banks happens to be sweeping over the world,” Hungarian Prime Minister Viktor Orban addressed parliament prior to the passing of a bank levy of 0.5 percent on assets of over HUF 50 billion, making it the highest in the world. Within four years, the country managed to raise HUF 843 billion (nearly €2.8 billion) through the new tax. But on the flip side, lending activities have fallen by a third, from €60 billion to €43 billion over five years, and banks have shifted part of the tax burden onto their customers by raising interest rates and fee margins. On top of that, some foreign-owned lenders, which started to generate losses, backed out of the country, selling their subsidiaries to the Hungarian state treasury. The renationalization of part of the sector was an offshoot of the new law. [negative]Setting alarm bells ringing that the bank tax will definitely harm lending activities in an exaggeration[/negative] Money for children Law and Justice, Poland's conservative party, which won the general election in October 2015, has never shied away from admitting to fashioning some of its policies based on those implemented by Orban. Although Poland didn't undergo a recession at the peak of the global crisis and wasn't forced to bail out its banks, the party promised to tax lenders and large retailers in order to finance its social spending programs. The PiS flagship benefit scheme, 500+, which is set to cost PLN 16 billion in 2016, involves handing out PLN 500 for every second and subsequent child and also for the first child if a family's per head income is lower than PLN 800. Since banks have recorded huge profits over the last couple of years, it was almost certain that the government would knock on their doors for money. Despite the fact that PiS claimed, throughout the election campaign, that it had its bills prepared, the shape of the levy was uncertain until the last moment. Prior to the final vote in parliament, the party said that it would tax assets of above PLN 4 billion at a rate of 0.39 percent a year, excluding equity and treasury papers. However, a few hours before the passing of the law, it raised the rate to 0.44 percent. The government budgeted PLN 5.5 billion in revenue from contributions in the 2016 budget. A blow to the economy? [caption id="attachment_94328" align="alignright" width="300"] Image: shutterstock[/caption] The new law raised serious concerns with many analysts voicing arguments that the levy may result in throwing the baby out with the bathwater as the high tax could curb lending activities and thus harm the economy. Although the banking sector recorded an impressive net profit of PLN 16 billion in 2014, last year wasn't as fruitful. This was due to numerous factors, including falling income from fees and interest rates, paying obligatory contributions to cover deposits of bankrupt credit cooperatives and social banks, and donating to a new fund for troubled borrowers. After deducting an additional PLN 5 billion from the new tax, the sector's profits may decline to PLN 6-7 billion this year, which could turn out to be too little to increase lending activities. But, according to Elżbieta Mączyńska, head of the Polish Economic Society, this doesn't have to be the case. She pointed to the fact that it is never one single factor that determines the number of loans taken. What counts is how the economy as a whole is developing. “There are numerous determinants which influence the decision to apply for a loan, including, among many others, the business friendliness of a country, the size of the market, the structure of the labor market, etc. Setting alarm bells ringing that the bank tax will definitely harm lending activities is an exaggeration,” Mączyńska said. In her opinion, it will surely be a daunting factor, but not one that's decisive in taking credits. In the case of Hungary, a decrease in lending activities was caused, not only by the tax, but also by a recession and the passing of a bill on the conversion of FX mortgage loans into the forint, a move that cost banks a few billion euros. For Mariusz Zygierewicz from the Polish Bank Association, falling lending activity is mathematics. He reminded that in line with regulations, banks need to have around PLN 12-15 of their own means to be able to lend PLN 100. Over the last couple of years, lenders have been putting away 75 percent of their annual profits so that they could raise the value of granted credits. “Banks need to have PLN 10 billion in profit to increase lending activity,” he explained. In the new situation, “considering capital constraints, banks would prefer to grant 40 loans with the highest yields instead of selling 100 cheaper products. 60 applicants would have to do without,” Zygierewicz said. [negative]PLN 5.5 bln is how much Poland budgeted in revenues from the tax in 2016[/negative] Shifting costs The other contentious matter is the issue of shifting the burden of the tax onto clients. “Without doubt, banks will try to do that,” Mączyńska said, adding that until recently, their operating conditions were luxurious, and now the environment is becoming less friendly. Nonetheless, the law of supply and demand still applies and since lenders live off credits, they can't overdo it with excessive provisions. The Ministry of Finance addressed the issue in a similar vein. It stated that, considering the fierce competition between lenders, some banks will use the opportunity to lure clients by keeping their fees at a constant level. In October, Finance Minister Paweł Szałamacha even declared that state-controlled PKO BP could invite competitors' customers to open accounts with them, suggesting that they wouldn't tinker with charges. But reality turned out to be harsh for the minister. A week before the tax came into effect, PKO BP announced that some of its products would cost more. The decision is easily understood by Zygierewicz. “Firstly, if it doesn't raise fees, the state will lose out on the money from dividends. Secondly, assuming that all customers choose PKO BP over its competitors, the bank would have to raise employment to service them all in a reasonable manner. However, it is not sure for how long the tax will be maintained. If its form changes in a year or two, the lender will be left with an employment surplus.” Although it is enshrined in the law that raising fees in connection with the levy is prohibited, the ban only applies to deals signed prior it coming into force. “Increasing prices won't compensate for the whole portfolio,” Zygierewicz said. But Mączyńska advises not to cry over banks' fate, reminding that they have enjoyed very high rates of returns in the past few years, much higher than companies from other sectors. And, they still have space to optimize their costs by broadening the scope of online banking services, for example. [negative]Banks will be able to swallow the tax[/negative] Apart from shifting the costs onto their customers, banks have a few other ways to circumvent the law. The legislation, according to the European Central Bank, may provide the incentive to transfer assets abroad and prompt lenders to restructure their portfolios in favor of riskier products. According to Zygierewicz, banks will not transfer retail banking activities because it would lead to increased employment in western countries where salaries are much higher, making the whole effort unprofitable. Nonetheless, transferring assets out of the country is very likely in corporate banking, particularly in those cases involving large projects of low profitability, for example the financing of shopping centers and alike. “I can see a risk that Polish banks will become some kind of information agencies, whose tasks would be to gather information from the market and send it to their parent companies,” Zygierewicz claimed. “Repolonization”? [caption id="attachment_94327" align="alignleft" width="300"] Image: shutterstock[/caption] The hidden motivation, just like in the Hungarian case, behind the high tax rate may be the willingness to renationalize the sector. These allegations can be confirmed by the election campaign statements put forward by PiS politicians. In March 2015, Andrzej Duda, then a presidential candidate, said that the state is powerless vis-a-vis the financial sector and this disparity stems from the fact that 70 percent of banks in Poland are foreign-owned. “There's only one demand – the renationalization of the sector, as banks do with us what they want,” Duda claimed. But to take over banks, the state needs money, and taking into account the social spending agenda, it is unlikely that Poland would be able to find a few billion złotys to finance such operations. In Zygierewicz's opinion, a larger concentration of Polish capital in the sector is not a bad idea, particularly in terms of supporting Polish exporters abroad. But the strategy of throttling banks in order to take them over and then rebuild them from scratch doesn't seem to be smart. “The ownership structure of the sector is good, none of the banks have a dominant position,” Zygierewicz said, adding that this move would be more understandable if there was one predominant foreign-owned bank. Otherwise, it might be art for art's sake. Taxing banks reasonably The idea of imposing levies on banks is not a controversial one, and many experts support it. “I am for taxing banks in the way proposed by Tobin to throw a spanner in the works of the financial sector so that it doesn't take control over the real economy,” Mączyńska claimed. But, Polish legislation causes concerns over the tax shape and its high rate. Although the levy poses little risk for the stability of the sector and banks will probably be able to “swallow” it, as the head of central bank Marek Belka stated, consequences for the economy and customers remain uncertain. In the best case scenario, in which Poland's GDP grows by nearly four percent a year (as it is projected to by international institutions), there are no bankruptcies of social banks or credit unions and the government doesn't pass a law on converting FX denominated mortgage loans, the banking tax probably won't harm the economy. But no one can assure that it will be that way. Additionally, passing the legislation with so many question marks just to reach a political goal is not the way economic policy should be carried out.