Regulation and Taxation: Economics and Politics

Abstract

We describe systemic financial risk as a negative externality. Free riding leads to excess risk production. We consider two instruments usually adopted to tackle this problem: financial regulation and taxation. From a normative viewpoint, taxation is superior in many respects. We take a positive, political-economy perspective. We show that a majority of low-risk portfolio-owners may have a strategic incentive to use regulation rather than taxation in order to charge the minority a large share of the externality reduction. We also show that, when the majority chooses a tax, the probable level is socially too low. If the majority chooses regulation, the latter will possibly be too harsh. This eventually explains why financial regulation is more frequently adopted, and why incentives to circumvent it are so strong in reality.