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Too Many to Fail - How Bonus Taxation Prevents Gambling for Bailouts

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  • Michael Hilmer

Abstract

Using a simple symmetric principal-agent model with two banks, we study the effects of both bailouts and bonus taxes on risk taking and managerial compensation. We assume financial institutions to be systemic only on a collective basis, implying support with bailouts only if they both fail collectively. This too-many-to-fail assumption generates incentives for herding and collective moral hazard. If banks can anticipate bailouts, they can coordinate on an equilibrium in which they collectively incentivize higher risk-taking. A bonus tax can prevent this excessive risk-taking, even if it is implemented unilaterally: proper bonus taxation reduces risk-taking of the taxed bank(s) and, consequentially, rules out the equilibrium with excessive risk-taking of both banks and reestablishes market discipline.

Suggested Citation

  • Michael Hilmer, 2014. "Too Many to Fail - How Bonus Taxation Prevents Gambling for Bailouts," Working Papers tax-mpg-rps-2014-18, Max Planck Institute for Tax Law and Public Finance.
  • Handle: RePEc:mpi:wpaper:tax-mpg-rps-2014-18
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    References listed on IDEAS

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    More about this item

    Keywords

    Bonus Tax; Executive Compensation; Bailout; Systemic Risk; Too Many To Fail; Collective Moral Hazard;

    JEL classification:

    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
    • J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • D62 - Microeconomics - - Welfare Economics - - - Externalities

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