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    Taxation Papers are written by the staff of the European Commission's Directorate-General forTaxation and Customs Union, or by experts working in association with them. Taxation Papersare intended to increase awareness of the work being done by the staff and to seek comments

    and suggestions for further analyses. The views expressed in the Taxation Papers are solelythose of the authors and do not necessarily reflect the views of the European Commission.

    Comments and inquiries should be addressed to:

    TAXUD [email protected]

    Cover photo made by Milan Pein

    Despite all our efforts, we have not yet succeeded in identifying the authors and rights holders forsome of the images. If you believe that you may be a rights holder, we invite you to contact theCentral Audiovisual Library of the European Commission.

    Ares(2009)123234

    This paper is available in English only.

    Europe Direct is a service to help you find answersto your questions about the European UnionFreephone number:

    00 800 6 7 8 9 10 11

    A great deal of additional information on the European Union is available on the Internet.It can be accessed through EUROPA at: http://europa.eu.

    For information on EU tax policy visit the European Commission's website at:http://ec.europa.eu/taxation_customs/taxation/index_en.htm

    Do you want to remain informed of EU tax and customs initiatives? Subscribe now to theCommission'se-mail newsflash at: http://ec.europa.eu/taxation_customs/common/newsflash/index_en.htm

    Cataloguing data can be found at the end of this publication.

    Luxembourg: Office for Official Publications of the European Communities, 2010

    ISBN 978-92-79-13469-2

    European Union, 2010Reproduction is authorised provided the source is acknowledged.

    PRINTED ON WHITE CHLORINE-FREE PAPER

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    The 2008 Financial Crisis and Taxation Policy

    Thomas Hemmelgarn1

    (European Commission)

    and

    Gaetan Nicodeme

    (European Commission, Universit Libre de Bruxelles, CEPR and CESifo)

    This version: 11thJanuary 2010

    Abstract: The 2008 financial crisis is the worst economic crisis since the Great

    Depression of 1929. It has been characterised by a housing bubble in a context of rapidcredit expansion, high risk-taking and exacerbated financial leverage, leading todeleveraging and credit crunch when the bubble burst. This paper discusses theinteractions between tax policy and the financial crisis. In particular, it reviews theexisting evidence on the links between taxes and many characteristics of the crisis.Finally, it examines some possible future tax options to prevent such crises.

    Keywords:financial crisis, tax policy, taxation, fiscal stimulus, financial transaction tax,property tax

    JEL classifications:E62, F21, F30, G10, H20, H30, H50, H60

    1The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and

    should not be attributed to the European Commission. The authors thank Jean-Pierre De Laet, Geoff Lloyd

    and Florian Whlbier for useful comments. They also thank Marco Fantini and Florian Whlbier for dataon property taxation revenue. Possible errors and omissions are those of the authors. Contact:

    [email protected] ec.europa.eu and [email protected] ec.europa.eu.

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    1. Introduction

    The 2008 financial crisis has severely hit the world economy. While taxes have

    not generated the crisis, some aspects of tax policy may have led to increased risk-taking

    and indebtedness of banks, households and companies. Tax incentives may indeed have

    exacerbated the behaviour of economic agents, leading them to wrong economicdecisions. There is evidence that tax systems around the world usually favour home-

    ownership for instance. This situation may in turn lead to too-high demand in the housing

    market, boosting prices, which, combined with lax lending practices, paves the way for a

    speculative bubble. On another note, the favourable treatment of debt-financing relative

    to other sources may lead to leverage practices that are not anymore driven by pure

    economic conditions. This in turn may put at risk companies during economic

    downturns.

    This paper proposes a detailed account of the conditions that have led to the

    banking crisis and the type of policy responses brought by the U.S. and the Member

    States of the European Union (EU). Monetary and regulatory policies have opened the

    possibility for a housing bubble which eventually burst and created a credit crunch

    because of a lack of confidence between actors on financial markets. Governments and

    Central banks reacted by a combination of capital and liquidity injections, regulatory

    measures and fiscal stimulus. A reading of the events and of existing economic literature

    makes us doubt that tax policy has been a major contributor to the housing bubble. There

    is however some theoretical suggestions that tax policy may have led to high levels of

    risk-taking because of the tax treatment of some executive compensation schemes and

    tax arbitrage possibilities on financial markets. Finally, we also find mixed arguments on

    the potential effects of a financial transaction tax to prevent future bubbles. Ending the

    preferential tax treatment of debt seems a more promising avenue to avoid risky leverage

    of firms.

    The paper is organised as follow. Section (2) provides an introduction to

    developments of the 2008 financial crisis and introduces the latest available (current and

    forecast) economic figures. Section (3) takes stock of the policy measures taken by

    authorities, in particular the recovery plans and the tax measures taken to fight the crisis.

    Section (4) offers a reflection on whether specific tax provisions may have aggravated

    the crisis by encouraging home-ownership and risky behaviours. In particular, it looks at

    developments in the housing markets, the compensation of executives, and the

    development of securitization. These three elements have played a major role in the

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    context of the crisis. Finally, the last section discusses some possible tax solutions to

    prevent future crises such as a transaction tax and tax systems that would be more neutral

    vis--vis the sources of financing.

    2. The build-up to the 2008 financial crisis.2.1. General economic conditions before the crisis.

    The events leading to the current financial and economic crisis are heavily

    debated and the dust has not yet settled on the real causes of the crisis. The arguments set

    in this paper are therefore somewhat speculative, subject to debates and will eventually

    be judged by History. Yet, a majority of commentators point to several elements that

    have facilitated an easing of credit and an increase in risk-taking.

    The economic conditions in the early 2000s were characterised by the end of the

    dot-com bubble which peaked in March 2000 before bursting until the end of 2002

    (figure 1). The reaction of the Federal Reserve to this stock market decline has been to

    ease economic conditions using declining interest rates. Accordingly, the U.S. Primary

    Credit Discount Rate was progressively lowered from 6.5% at the peak of the bubble in

    mid-2000 to 1% by mid-2003 (figure 2)2.

    Figure (1): Nasdaq Composite Index 1993-2004

    Nasdaq Composite Index

    0

    500

    1000

    1500

    2000

    2500

    3000

    3500

    4000

    4500

    5000

    5500

    4/01/1993

    4/05/1993

    4/09/1993

    4/01/1994

    4/05/1994

    4/09/1994

    4/01/1995

    4/05/1995

    4/09/1995

    4/01/1996

    4/05/1996

    4/09/1996

    4/01/1997

    4/05/1997

    4/09/1997

    4/01/1998

    4/05/1998

    4/09/1998

    4/01/1999

    4/05/1999

    4/09/1999

    4/01/2000

    4/05/2000

    4/09/2000

    4/01/2001

    4/05/2001

    4/09/2001

    4/01/2002

    4/05/2002

    4/09/2002

    4/01/2003

    4/05/2003

    4/09/2003

    4/01/2004

    4/05/2004

    4/09/2004

    Source: Yahoo! Finance

    2

    Note that the Federal Reserve most certainly also tried to combat the economic consequences of theSeptember 11th, 2001 terrorist attacks. The U.S. economy was also in a context of low inflation, if not of

    deflation risk, which facilitated an ease in monetary policy.

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    Figure (2): U.S. Fed Discount Rate 2000-2009

    US Federal Reserve Funds Target Rate

    0.00

    0.50

    1.00

    1.50

    2.00

    2.50

    3.00

    3.50

    4.00

    4.50

    5.00

    5.50

    6.00

    6.50

    7.00

    5/01/2000

    5/05/2000

    5/09/2000

    5/01/2001

    5/05/2001

    5/09/2001

    5/01/2002

    5/05/2002

    5/09/2002

    5/01/2003

    5/05/2003

    5/09/2003

    5/01/2004

    5/05/2004

    5/09/2004

    5/01/2005

    5/05/2005

    5/09/2005

    5/01/2006

    5/05/2006

    5/09/2006

    5/01/2007

    5/05/2007

    5/09/2007

    5/01/2008

    5/05/2008

    5/09/2008

    5/01/2009

    5/05/2009

    5/09/2009

    5/01/2010

    %

    Source: Federal Reserve

    A second characteristic of the world economy in the early 2000s was massive

    inflows of capital on international financial markets. The U.S. Capital and Financial