In a cost of living crisis and amid high interest rates, the concept of a windfall tax on banks’ profits is currying favour with governments. Italy’s administration is the latest to consider such a proposal, after it suggested a one-off levy on banks’ net interest income. It then quickly backtracked on the levy’s scope after the share prices of Italian banks plummeted. The proposal will now make its way through parliament for ratification.
But should we now expect to see windfall taxes become a part of the playbook for governments looking to appease voters as the cost of living crisis continues to bite? And are such taxes justifiable in the wider economic context?
Windfall taxes, as with all levies, are a political decision. They may be pursued to prevent profiteering, redistribute wealth, prop up struggling government balance sheets, or any combination of the three. They are now especially attractive to governments in view of their suffering balance sheets and as banks’ net interest income margins expand.
Though it appears primarily to be a policy of the left, the introduction of a windfall tax last week in Italy – led by the right-leaning Meloni government – shows that its strongest relation is political opportunism. The low-hanging fruit that is lenders’ profits makes for easy pickings as it is uncontroversial among voters.
“When you’ve got very unusual circumstances, like we have right now with this rapid rise in interest rates, then you’re more likely to have these kinds of things happening,” says Elisabeth Rudman, head of global financial institutions at rating agency DBRS Morningstar.
We have already seen windfall taxes introduced in a number of countries across Europe as interest rates have ramped up, including the Czech Republic, Hungary, Lithuania and Spain. They aim to solve a variety of issues, whether that be relieving energy costs (the Czech Republic and Spain), funding the military and other sectors (Lithuania), or containing the budget deficit (Hungary).
When you’ve got very unusual circumstances, you’re more likely to have these kinds of things happening
The Italian government’s given purpose for collecting the tax is to reduce fiscal pressure and to support first-time buyers in the housing market. It arrives at a time when the profitability outlook for the Italian banking sector is improving. “If we look at the Italian banks, the general view is clearly that banks in Italy have made a lot of progress in profitability and asset quality and ability to generate capital organically,” says Andrea Costanzo, vice president, European financial institutions at DBRS Morningstar.
While banks have indeed benefited from the high interest rate environment, improved performance, too, has played a role. “This is not only a consequence of net interest income because we have also recognised that there has been good resilience from fee income, good cost management, then loan loss provisions have decreased,” continues Mr Costanzo.
This outlook is not limited to Italy. “There’s been quite significant improvements in European banks, actually, over the past year or two years, and particularly for the southern European banks,” says Ms Rudman.
It is important to note, she says, that “the European banks of course have been a lot weaker from a profitability point of view than many other banking systems for quite some time” – and still are compared to banks in, for example, the US, Canada and Australia.
European banks are, however, in “something of a sweet spot”, says Ms Rudman, “because the net interest income from their lending has increased, but there hasn’t yet been really a significant asset quality problem related to the weakening economy and pressure on their borrowers.
“We had anticipated that there could be a downturn for profitability a bit earlier and it hasn’t happened.”
Abroad of Italy
Given the high profits of banks amid wider economic pressures, why haven’t more European countries implemented a windfall tax on their domestic lenders?
“[It’s] a matter of politics,” says Antonio Fatás, professor of economics at business school Insead. “In the case of Spain, you have a government which is fairly leftist from a political point of view, running a government trying to extract more taxes from the rich, from companies that make excessive profits.” Spain proposed a windfall tax on its own banks – along with its energy majors – which was approved late last year.
Per-country factors have an influence, too. “The story of Italy might not apply everywhere, because in other places, maybe [deposit] accounts pay a much higher interest rate than in Italy today,” says Mr Fatás. Despite criticism, this has been true of the UK – at least partially. “In the UK, many banks have passed some of these interest rates to their customers. Not 100%, but some. If you go to Spain or to Italy, most banks have not passed on any of the interest rate increases.”
Another influence is legislative. “In France, they have really quite regimented rules – their usury rules – around the interest rates that can be charged on lending, and also they have certain regulated deposits,” explains Ms Rudman. This has not prevented the French government, president Emmanuel Macron included, from putting verbal pressure on banks to share their profits.
If [the Italian windfall tax] were successful in any way, other governments could say: ‘Look, why are we not doing this?’
Whether other European countries, individual characteristics notwithstanding, are likely to implement their own windfall tax is another question. “I don’t think so, [but] they could,” says Mr Fatás. “If [the Italian windfall tax] were successful in any way, other governments could say: ‘Look, why are we not doing this?’.”
Italy’s careless approach in announcing its tax may, however, have acted as a repellent. “Italy, having faced a certain amount of volatility in the response to their initial tax, might also put some countries off doing a tax, potentially,” says Ms Rudman.
“It will remain a point of debate until something changes – if we were to see bankruptcies increase, non-performing loans increase, banks making higher provisions, then the debate might start to disappear,” she continues. “I think banks are more likely to try and see if they can avoid getting into this situation by more proactively increasing rates that are paid to depositors.”
Unintended consequences
As with any government decision, windfall taxes have the potential to result in undesired effects. One point precipitating raised eyebrows, says Ms Rudman, is whether an attempt to give financial support to a group of individuals runs counter to another pressing matter: the battle against inflation. In other words, the very reason for the rapid rise in interest rates.
“Of course, they do want banks to continue to lend into the economies during times of stress in the economy,” says Ms Rudman. “You can understand why they might want to make some moves like this, but they have to be careful not to do too much.”
Another issue relates to the rules of the free market, and the risk that overburdensome taxes could create a disincentive for investment and risk-taking. But, to Mr Fatás, this is an argument – at least in these circumstances – that is irrelevant. “Banks in Europe aren’t going to stop running their businesses because of these one-time taxes.”
“In the short run it’s much more about uncertainty. Uncertainty can be tolerated if it’s a one-time event,” he continues. “That doesn’t have a lot of economic damage, because it’s a one-time event associated with hopefully a one-time political disaster, which is the war in Ukraine.”
Regardless of inadvertent outcomes, the risk of taxation of this kind arising elsewhere in Europe is certainly present, although it largely depends on local conditions. As Ms Rudman warns: “Italy taking a step will probably push the debate in other countries.”
