Proxy VAT on banks makes sense

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The Independent Online
The poor old banks. They share an unfortunate fate with the Royal Family and Christmas television schedulers in being objects of unwelcome intense public scrutiny. Complaining about them is good sport; almost everybody has a point to contribute or a story to relate. In the case of the banks, the Consumers' Association and the Small Business Federation conduct what appear to be almost weekly surveys of public dissatisfaction to collate the worst horror stories.

The banks are now entering their reporting season. As the profits they will be reporting for the year just ended will be the best for years, it is once again open season for bank-bashing. This year the Labour Party has joined in the game with more than customary relish.

But a question arises out of all this: just how much interference should policy-makers allow themselves in the workings of what is a reasonably competitive industry? Pretty well everyone recognises a need for regulation of sectors such as electricity, inwhich consumers cannot generate change by taking their business elsewhere. But what about an industry like banking where there are many choices, of big and small, commercial and mutual, British and foreign?

Few people would like politicians to have much say in what goes on television at Christmas. So why do we "jump for joy" when politicians get stroppy about the terms on which we do a deal with our bank?

If one bank offers a bad service, surely consumers will punish it themselves by taking their business elsewhere. Interference would be gratuitous. If, on the other hand, all the banks are bad, which appears to be what is argued, then one should think even more carefully about applying new regulations.

For example, if banks en masse charge a lot for writing a letter informing you that you have an unauthorised overdraft, then it may be that there is a good reason for charging a lot. Instead of being an exploitative charge for the postage, it may be justa clever banker's way of discouraging unauthorised overdrafts.

Unless there is some good reason for it, competition should in theory drive the banks away from a bad habit. Experience shows that it is difficult to maintain a cartel in a business with so many players.

Some would say that banks are a special case. Switching accounts is more costly than switching from one brand of coffee to another. To that extent, bank customers are prisoners. It makes new entry into retail financial services difficult, and could be a reason for banks making abnormally high profits.

While there is something in that, there are strong reasons to be wary of inviting government or regulators to become too involved in the sector. As with all intervention, even were it desirable in principle, it can easily be flawed in practice. Much of the analysis we have heard about the banks is populist in tone, rather than reasoned. It provides a poor basis for policy-making.

Financial services are like electricity and telecommunications. They are more important to a flourishing economy than their value added would reveal. We should probably err on the side of having banks that are too profitable, rather than not profitable enough.

In any event, it is very difficult to judge whether profits are too large or too small in any sector. When you look at the profits of British banks, appropriately measured, much of the apparent froth disappears. The financial service experts First Consulting have looked at the profits of European banks over the half-decade from 1987 to 1992.

That is a long enough period to make a proper judgement. They also look at different measures of performance that take into account the amount of shareholder capital tied up by the banks. The more capital tied up, the bigger profits ought to be. There isno scandal in that.

If you look at their return on equity, the British banks have a record of lower but also more volatile profits than their Continental counterparts. The same picture holds for more sophisticated measures used by the consultants. The figures give no support to those who say that the banks are making excess profits.

So does this mean there is nothing the politicians can do? Can public irritation with their banks not be expressed in some sensible policy reaction? Was Gordon Brown's time well used this week, in arguing for a new Banking Act? The answer to that is yes.

The substance of the Labour proposals was in marked contrast to the huff and puff with which it was delivered. For one thing, there was sensibly no talk of a windfall profits tax - which would simply cream off the profits in the good years in the cycle, and leave the banks with smaller reserves to weather the bad years. And there was no real talk of a new Ofbank, with price or profit-setting powers. Labour avoided the trap of trying to regulate a competitive industry.

Instead, the measures were about disseminating information and clearing possible market blockages to promote new entrants, notably in the clearing system. The measures are far more restrained than you would have expected some years ago.

The Conservatives have also been at the banks, and they too have avoided the temptation to score populist points with a delicate industry. Reports emerged last week of Treasury discussions on the subject of a new credit card tax - a natural sibling of the airline and insurance taxes introduced last year.

In as far as such a suggestion is practical, it is awful. It would almost certainly inhibit the modernisation of our payments systems. But the Chancellor would be right to follow his train of thought. The banks, like airlines and insurance companies, do not pay value-added tax. That's not because we like banks in the way we like newspapers, books or fuel; it is because, administratively, VAT is hard to apply to banks.

The search for a proxy form of VAT would be a perfectly sensible, and non-interfering, kind of policy. It would be fiscally neutral, and indeed, the European Commission is researching ways of getting taxes on retail financial services to make up for the VAT hole. But whether it happens depends on whether we are more interested in rhetoric or common sense.

Evan Davies, formerly of the Institute of Fiscal Studies and London Business School, is now Economics Correspondent of the BBC.