On Budget night, the Treasurer announced a raft of infrastructure spending and other measures which are to be funded by some key tax increases, namely the Medicare levy increase and a new tax on the five largest banks in Australia. This blog post focuses on the latter - putting aside the politics, let's have some fun with economics, shall we?
The Policy
From 1 July 2017, Authorised Deposit-taking Institutions (ADIs, read: banks) with liabilities of $100 billion will be subject to a six basis point (0.06%) levy on these liabilities. A levy usually works by taking a proportion of the whole amount that is over a threshold, so a bank with $100bn + $1 of the right liabilities, would owe the Tax Office about $60 million. The measure is projected to raise about $1.5bn each financial year over the forward estimates period (read: the next four years), for a total of $6bn. (http://budget.gov.au/2017-18/content/bp2/download/bp2.pdf)
Who is affected
Currently, the only banks affected by this measure are the Big Four (Westpac, Commonwealth, National Australia Bank, ANZ) and Macquarie Bank (http://www.abc.net.au/news/story-streams/federal-budget-2017/2017-05-09/federal-budget-2017-big-banks-bear-the-brunt/8511364). The Treasurer, Scott Morrison, has been at great pains to state that it doesn’t affect “pensioners’ and others’ ordinary deposit accounts, nor is it on home loans”. This is technically correct - the budget papers state that the liabilities subject to the levy include “corporate bonds, commercial paper, and Tier 2 capital instruments” and are not applied to “additional Tier 1 capital and deposits of individuals, businesses and other entities protected by the Financial Claims Scheme”. So the calculation for the banks will be something like, take the sum of all your liabilities, subtract the Tier 1 stuff and multiply by 0.06% to figure out what they owe the Tax Office.
However, this policy ignores some fundamental economic theory - namely, tax incidence. Tax incidence is a fancy term for saying “who actually ends up paying for this?”.
Economic Theory Time
Tax incidence can be worked out by considering the price elasticity of supply and demand. In this case, supply and demand could be across a whole range of products and services (e.g. financial advice, insurance, mortgages, bank accounts etc.). But for simplicity, let’s stick with mortgages.
The demand side is probably more intuitive, so let’s start there. How likely are you to change mortgages if your interest rate moves slightly? Chances are, not very likely. Researching and comparing mortgages is a pain in the arse, and most people would rather do just about anything else with their time. OK, what about if you were considering taking on a new mortgage - would a small increase in the interest rate prevent you from taking it out? Probably not, for a whole raft of reasons. In this case, the price elasticity of the demand for mortgages is said to be relatively inelastic. That is, changes in price do not have much effect on demand (people taking out or changing mortgages).
What about the supply side then? This is a little more complicated, because each individual bank has the ability to determine its own interest rates, albeit with some big influencing factors such as the underlying cash rate maintained by the RBA etc. Additionally, new loans are somewhat constrained by prudential regulation, such as requirements to hold certain amounts of different forms of capital (the tiers we saw earlier), and for example, the recent new caps applied to interest-only loans (http://www.abc.net.au/news/2017-03-31/apra-clamps-down-on-interest-only-mortgage-loans/8403712) and so forth. Loans for new housing are also constrained by the land available for development - you can’t borrow to build a house on land you are not allowed to build on in the first place! Let’s keep these in the back of our mind as think about price elasticity.
So what about the price elasticity of mortgage loan supply? How likely will a bank be to offer more loans (subject to the constraints we discussed before) if it can charge a higher interest rate? Very likely. More loans at higher interest rates, means more returns and profits for the bank. The kicker is whether the size in the increase in the amount of loans offered at the higher price is greater than the increase in price. That is, if price goes up a little, does the amount of loans supplied go up a lot? If this is the case, then supply of mortgage loans is said to be relatively elastic. That is, increases (or decreases) in the price, has a considerable effect on the amount of loans a bank is willing to supply. I think this is a fair assumption to make.
So we have price inelastic demand for loans and price elastic supply of them. The supply and demand curve diagram would look something like the below (though probably with a more horizontal supply curve, to indicate the higher elasticity).
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We begin at the point (P without tax, Q without tax) - our current equilibrium point. The imposition of the levy raises the price to P with tax. Due to inelastic demand for mortgages, the quantity demanded drops a little, and the supply curve shifts (to the left, as the quantity supplied is now lower). A new equilibrium point is reached at (P with tax, Q with tax), where a lower quantity of mortgages are demanded at a higher price (interest rate). The tax incidence is shown as the differences from the previous equilibrium point. Moving from (P without tax, Q without tax) along the supply curve to the new quantity supplied (Q with tax), we see that a part of the tax has impacted suppliers; they now supply fewer loans at higher prices. Moving from (P without tax, Q without tax) along the demand curve to the new quantity demanded (Q with tax), we see that there has also been some impact on consumers; they now demand fewer loans at the higher price. We see that, due to the relative elasticities of demand and supply (the slopes of the curves), there is relatively higher incidence of the tax on consumers (loanees), rather than producers (banks). Whether consumers or producers face a higher incidence depends on the relative elasticities of supply and demand (i.e. it depends on what the curves actually look like) - the above example is purely illustration.
That’s all very nice in theory, what’s the reality?
Supposing that the levy gets through parliament (which it probably will), these bigger banks will have an extra bill to pay. They could get the money to pay for this by either reducing their profits, making their own operations more efficient, and/or increasing prices to customers. Reducing profits and therefore dividends (the incidence on producers above) will probably upset shareholders, of which your superannuation fund probably forms a sizeable part. Banks will most likely want to avoid this at all costs. In my opinion, further increasing operational efficiency is unlikely. In all likelihood, it will be some combination of all of these things, but I think primarily it will be sourced by passing it on to consumers through minor increases in prices (fees and interest rates).
Of course, Turnbull and Morrison aren’t stupid - they’ve already said that the Australian Competition and Consumer Commission (ACCC) will be watching these banks closely for signs that this may be passed on. However, as best put by the ABC, while “[t]he ACCC will be able to force the banks to explain any changes to home loan pricing, including fees or interest rates, during that period, although it is unclear anything could be done to prevent those price rises”. If you have accounts or a mortgage with one of the aforementioned banks, I think it’s prudent to be prepared for a small increase in either your fees or rates but don’t expect them to cite the government’s major bank levy as the reason.
However, because this only applies to five major banks and not everyone, there is nice little constraint on the affected banks to be careful about increasing their fees and rates - namely, that you the customer could take your business elsewhere. While there is some obvious inertia (see: comparing banks/mortgages is a pain in the arse), some customers at least will change banks if they are too gung-ho about passing the tax on. The takeaway being that, you have the power to avoid this potential problem, so long as you are willing to endure the very boring process of comparing financial institutions and products.
Your thoughts?
Of course, much of this is purely speculation given that there is very little policy detail as far as I can tell. Do you think it’s good policy? Bad policy? Why/why not? What would be your alternative proposal? Do you think it has support to get up, from the community, the pollies or both?
I’d love to hear your thoughts.
