Taxation, bailouts and financial supervision

This paper explores the interaction between foreign-debt bailout guarantees, financial supervision and optimal factor taxation. The context is that of a pre-“twin crises” emerging market economy and the analysis is undertaken using an original stylised two-period model based on the insights of the “third-generation” currency crisis literature. Bailout guarantees lead to moral hazard problems as banks monitor less and lend more than is socially desirable. As such, the solution of the government’s Ramsey taxation problem under bailouts entails a corrective rationale for capital taxation, implying a higher tax-rate than would otherwise be the case. When complementary regulatory instruments, such as effort-adjusted capital-requirements, are available to government, this capital tax-rate decreases with an increase in supervisory effectiveness. The paper’s conclusion is that bailout guarantees should only co-exist with some form of effective banking supervision to ensure that the effects of moral hazard are mitigated, which reinforces the view that emerging economies can signal their financial reputation and also contribute to reducing the risk of future crises only by implementing good governance and effective supervisory procedures in their financial systems.