Some Perspective on Italy’s Post-Hoc Bank Tax

This has probably been a challenging week to be a bank executive, and not just because credit rater Moody’s downgraded several American banks’ credit ratings on (in our view) old news Tuesday.^[i] Late Monday evening, the Italian government announced plans for a windfall profits tax on its banks for 2023.^[ii] The news initially hit Italian bank stocks hard as investors seemingly reassessed earnings quickly.^[iii] Many commentators we follow suspect this is why Italian officials adjusted the plan the next day, capping the value of lenders’ tax payments to no more than 0.1% of their assets—lower than previous estimates tax payments could hit closer to 0.5% of assets.^[iv] As a result, many of the same stocks that fell on Tuesday began climbing back Wednesday.^[v] Despite the tax plan being watered down, we think it is worth considering how it might impact the overall economic and market landscape—and whether it adds headwinds materially above and beyond what markets have seemingly already priced in. Spoiler alert: Whilst we don’t think taxes like this are a net benefit, we doubt it materially changes economic fundamentals.

In our view, the plan ostensibly frames European Central Bank (ECB) monetary policy as delivering banks unjustified profits. This hinges on the notion ECB policy drove up loan rates whilst banks haven’t passed the full brunt of short-term rate hikes on to their depositors, similar to the situation in Britain. Hence, net interest income (loan interest revenue minus funding costs) rose. Whatever you think of that, it appears to be the rationale underpinning the move.

Several commentators we follow described the tax as a 40% windfall profits tax, which sounds quite big, but that isn’t quite right. The government will not be taxing all bank profits at 40%. Rather, it will apply this rate to the amount of money politicians think is an undeserved windfall from rising interest rates. The plans define windfall profits as net interest income in excess of 10% growth between 2021 and 2023 or in excess of 5% growth between 2021 and 2022, whichever is bigger.^[vi] Not great, in our view, but not as bad as many commentators we follow implied—especially when considering yesterday’s adjustment.

Furthermore, the tax still must receive Parliamentary approval within 60 days to become law.^[vii] Prime Minister Giorgia Meloni’s right-leaning coalition has a majority, and her Brothers of Italy party is the largest group in Parliament, but we don’t think that automatically means it will avoid further tweaks.^[viii] Winning support from coalition partners the League and Forza Italia may require Meloni to water the tax down further during the budget process in September and October. Since taking office, Meloni has tacked to the centre on numerous proposals in order to push legislation through, so further adjustments to the windfall tax could easily become another example.

As it stands now, the tax doesn’t strike us as a massive negative for Italian banks if it takes effect. Like their eurozone peers, Italian banks are very well capitalised and have abundant liquidity, so their flush balance sheets should have no trouble absorbing the small hit.^[ix] When Spain passed a similarly small windfall profits tax last December, markets seemed to move on pretty quickly.^[x] We doubt this time goes differently, especially with the tax limited to this year only (at least, as presently constituted).

However, we think it would be too dismissive to estimate the macroeconomic impact at zero. Our research suggests retroactive taxes like this tend to raise uncertainty, as they introduce the prospect of further after-the-fact changes. It stands to reason that businesses have a hard time estimating the return on an investment if there is a chance the government could alter the taxes on that return after the fact, potentially introducing uncertainty that can deter risk taking. It isn’t possible to calculate how much investment Italy might lose out on because this tax move makes businesses skittish, but some projects could get delayed.

In our view, the other main conduit for this to hit the economy is if the tax discouraged lending. This is possible, but we think it is a stretch to pencil in a huge decline. Since the tax applies only to 2023 earnings, we think the likelihood it would materially affect 2024 lending plans seems low. Yes, uncertainty over a potential 2024 tax could factor in, but consider that ECB interest payments on minimum reserves—which have added to net interest income—stop next month.^[xi] The euro amounts in question here aren’t huge, in our view, but simple maths would suggest continued lending is necessary to support net interest income as ECB interest drops. With that said, Spanish loan growth has been negative since Spain’s bank tax took effect last December.^[xii] Yet even that doesn’t look like cause and effect, in our view, considering lending actually started dropping several months beforehand on a month-on-month basis.^[xiii] Incidentally, Italian loan growth rolled over around the same time, also on a month-on-month basis.^[xiv] So, we think the question is really whether the tax adds lending headwinds significantly above and beyond what banks already face. To us, it seems unlikely. Other factors probably loom larger.

Then, too, we think it is also important to weigh this development against broader sentiment toward Italy’s economy, which based on the latest coverage we track appears to be quite low. Italy was the only one of the eurozone’s four largest economies to suffer falling gross domestic product (GDP, a government-produced measure of economic output) in Q2, which seemed to fuel resurgent pessimism.^[xv] Publications we follow have warned earlier signs of economic resilience are now extinguished, as if one quarter’s contraction is automatically a self-fulfilling prophecy. In our view, weak economic expectations suggest sluggish lending is already part of the calculus, sapping its surprise power. Plus, Italian stocks’ bear market (a prolonged, fundamentally driven broad equity market decline of -20% or worse) in euros last year likely pre-priced the current economic weakness to a very great degree.^[xvi] We will note, too, that we aren’t seeing many argue the government’s plans to redistribute the windfall tax revenue via mortgage assistance and household tax cuts are some massive stimulus. Which, we don’t think they are, as our research suggests redistribution mostly just shuffles economic activity rather than creating it. But commentators we follow have a long history of framing these initiatives as positives, making the absence of cheer a notable sentiment marker, in our view.

So whilst we don’t think a windfall profits tax is great news or beneficial for Italy’s economy, we doubt it adds up to some huge net negative. Rather, it seems like the kind of small speedbump we find markets have become adept at swallowing the past couple years, much as they swallowed Spain’s bank tax, the UK’s energy windfall profits tax and several others.^[xvii] We don’t think this propensity for governments to declare profits unjustified is good, and in our view, this policy has clear downside potential if it were implemented on a broader level. But that doesn’t appear to be here now. So watch for unintended consequences, but we wouldn’t pencil in a big, bad economic impact.