Sunday, March 17, 2013

Cyprus Levy: Historical Precedents

In 1991, in response to considerable debt management concerns among European nations, Barry Eichengreen wrote a paper called "The Capital Levy in Theory and Practice." A capital levy on wealth-holders with the goal of retiring public debt was perhaps the most controversial proposed solution to the European public debt problem. Eichengreen provides a theoretical framework for considering the effects of such a levy, a list of challenges to successful implementation, a "catalog of failed levies," and an example of an exceptionally successful levy. Eichengreen's framework and lessons from history are useful for considering the levy on savings in Cyprus that is planned as part of Cyprus' 10 billion euro bailout.

Eichengreen's model uses insights from the literature on time consistency and government reputation. If governments could commit to only issuing capital levies under certain circumstances (in technical terms, if capital taxation is a state-contingent claim with full commitment mechanism), then governments could optimally issue levies when government obligations are unusually high, social returns to spending are unusually high, and/or conventional revenues are unusually low. "If the contingencies in response to which the levy is imposed are fully anticipated, independently verifiable, and not under government control," he writes, "then saving and investment should not fall following the imposition of the levy, nor should the government find it more difficult to raise revenues subsequently."

Of course, there are major practical impediments  First, full government commitment technology does not exist. If a government were to precommit to a plan for how its capital taxes would respond to future contingencies, it would end up having an incentive to renege on its commitment. Knowing this, savers would shift their capital to tax havens. Reputational concerns can partially get around this problem. The model describes how a "reputational equilibrium" can result if savers refuse to repatriate their capital for a certain amount of time following a government's decision to renege on its commitment. Another major impediment is the following:
"In a democracy, there is no independent authority to verify to the satisfaction of savers that the realization of the state of the world in fact justifies a capital levy. Even if savers recognize that capital taxation is a contingent claim, they retain the incentive to dispute that the relevant contingency has arisen. Neither is there a mechanism to prevent the government from pursuing policies that strengthen the case for capital taxation -- for example, increasing ordinary expenditures as levy receipts roll in. Savers will accuse the government of succumbing to moral hazard and resist the levy on those grounds... If the levy is imposed at all, typically this will occur only at the end of a protracted and divisive political debate...If there is an extended delay between proposal and implementation of the levy, capital flight is likely to render the measure ineffectual."
In light of these impediments to the successful use of a capital levy, Eichengreen analyzes a number of previous levies, mostly in the aftermath of World War I, and explains why they obtained varying degrees of failure or partially success. His first example, however, is not from post-WWI but rather from the ancient Greeks. They used periodic capital levies of one to four percent which, it is said, were "phenomenally successful because property owners, out of vanity, overstated the value of their assets!" Capital levies were also proposed, but not adopted, following the Napoleonic wars, the Franco-Prussian war, and other periods of major military expenditure. But the end of WWI was the true hey-day of the capital levy.

Italy imposed a capital levy in 1920. The rates ranged from 4.5 to 50 percent; however, payment could be stretched out over 20 years. Thus, it was successful but not too comparable with the Cyprus levy, which would be paid at once. The Czech levy of 1920 is more comparable with the Cyprus levy, and was more successful than levies in Austria, Hungary, and Germany at that time. In Czechoslovakia, a levy on all property was imposed, with progressive rates from 3 to 30 percent, with a separate surtax on the wartime increment up to 40 percent. There are two main reasons this levy was relatively successful. First, the levy fell mainly on a small ethnic German minority, which was unable to mount effective political resistance to delay adoption, so capital flight was minimized. Second, the government budget was structured so that levy revenue was completely separate from day-to-day government operations. The levy was explicitly devoted to extinguishing debts and meeting the special costs of establishing a newly-independent nation. This "lent credibility to claims that the levy was an extraordinary tax whose repetition was unlikely."

Other countries' levies were less successful. In Austria, political delays dragged on so long that asset holders had more than a year to prepare, so capital flight was extensive; moreover, hyperinflation liquidated levy obligations. Similarly, delays in other countries enabled capital flight. In Britain, a levy was long debated but never imposed. Keynes himself weighed in, initially in support of the levy, but later opposing it by the mid twenties, when postwar exceptional circumstances were further in the past.

The Japanese levy after World War II is Eichengreen's example of the exception that proves the rule. It was successful because the typical impediments to success were negated by the exceptional circumstances. Capital flight was limited, and the levy applied primarily to a small minority of individuals considered to have profited greatly from the war. In 1946-47, Japan's sovereignty was severely abridged by occupation forces. Thus "with important elements of democracy in suspension, the levy could be quickly and effectively implemented. One might go further and argue that only when political sovereignty is suspended can the measure be pushed through with such alacrity." Also, since the levy was essentially imposed by outsiders, it did not damage the Japanese government's reputation too much or adversely impact the ability of the Japanese government to raise revenue subsequently.

Lessons for Cyprus

A common theme of levies in the 20th century is that delays, usually politically-induced, cause capital flight and prevent the levy from raising a successful amount of revenue. The Cypriot parliament has already delayed its vote on the deposit levy to Monday. We will see how long the proceedings drag on. In Cyprus,  the levy will fall in large part on foreign depositors, particularly Russians, like the Czech levy fell mainly on Germans. It is not clear whether foreign depositors will prove as unable to mount political resistance in Cyprus as the Germans were in Czechoslovakia.

The levy in Cyprus is progressive, like it was in Czechoslovakia, although not to the same extent. The rate is 6.75% on deposits less than 100,000 euros and 9.9% on larger deposits. According to Eichengreen, a crucially important feature of the successful Japanese levy was the "sociopolitical argument," or the fact that the levy was imposed on people who were seen as having profited unjustly from the war. Engineers of the Cypriot levy may make the case that it is imposed on Russian money launderers or other wealthy depositors funneled their money there for less than admirable reasons. This case might be easier to make if the levy were more progressive-- if it hit bigger accounts harder, and were easier on the small accounts.

The Japanese levy did not adversely impact future Japanese governments' ability to borrow because it was imposed by outsiders. The Cypriot government may also be able to point to the IMF and EU as the masterminds behind this levy. The bigger issue, though, is whether other EU countries will suffer reputational penalties by virtue of association.

Finally, what worked really well for Czechoslovakia was that the levy revenue was totally separated from other tax revenue and dedicated strictly to paying off debt and to the needs of the extraordinary circumstances. It was not used to fund day-to-day operations of the government. That made it seem less likely that the government would be tempted to impose another levy in the near future. That is a feasible option for Cyprus, which they will hopefully employ.


  1. The fatal flaw in Cyprus is that the levy is put in place without a lender of last resort. This makes promise of non-repeatable levy not respectable. In turn this leads to a bank run. See why here

  2. Great post, Carola! I didn't realize wealth levies had been tried before.

  3. I agree with Alexander. Success in terms of revenue raised is not the measure of concern with the Cypress deal.

    The question as with most Eurozone issues of the moment doesn't have a ready precedent always for the same reason. There hasn't been a Currency Zone like the EU before. Sure there was the Ruble, various currency pegs, the gold standard, the Austro-Hungarian currency etc. but all with enough meaningful differences to provide little more than clues and suggestive hints.

    So the question with Cyrpess is Spain, Italy, Portugal, Greece, not Cypress. Will there be bank runs, has the EU undermined the trust in the banking system outside of Cypress?

    I am not sure what deposits did in the examples you cite, but in any case, every example covered all deposits/wealth of a given currency, in this case its only one small slice - and apparently not even for all of a banks deposits, deposits of overseas branches of cypriot banks will not be levied.

  4. "Reputation penalties"

    The lingo of the mental captive

    This reads like a Martian wrote it
    A Martian or a robot

    Please prove you are not a robot

    Take a position
    at least thru word choice

  5. The case narratives are very suggestive however
    And you really get to the core
    of this Fork in the "social choice" pathway

    Hit an isolate-able "other"

    And use the levy's takings to reduce the social burden of
    Excessive debt

    Controlled financial repression
    Is boring in comparison

    The lightly draw analogy to occupied japan
    Ought to liven the national knee jerk

    "The ECB done it"

    So long as the pols can prove personal loses at least as great as their fellow ordinary citizens ....blah blah blah

    I say
    In appropriate contexts
    --- this isn't one of them by my lights ---

    damn the " reputation and commitment problems"
    levy away

  6. And while levies are imposed on depositors, what is the fate of the banks creditors?

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