Excess profit taxes on financial sector will change credit environment

Estonia remains the only Baltic country where banks are exempt from excess profit tax. This tax already exists in Lithuania and is promised to be introduced in Latvia. In all these countries, there are also implemented ratios between credit (debt) and the borrower’s income.

This is according to a study by A/S BDO on special taxes for banks in the Baltics. Lithuania was the first Baltic state to introduce a special tax on banks. The so-called “bank windfall tax”, which taxes excess profit for credit institutions, is not a Lithuanian innovation, as similar taxes exist in Hungary, Spain, and the Czech Republic. “In the 1980s, the United Kingdom introduced a retroactive solidarity tax on banks. This tax targeted profits that were not derived from traditional risk-taking and lending activities, būt rather from unique situations like the current one, where the Bank of England has raised interest rates to curb inflation”, explains Maryam Sultanova, an analyst at BDO Latvia, referencing the study’s data. She notes that the formula for calculating the windfall tax varies from country to country. Pioneering Lithuania “In Lithuania, a tax rate of 60% will be applied to net interest income that exceeds 50% of the average in the last four financial years. In Latvia, there is a proposal for the financial sector (not just commercial banks, būt all those working in this sector) to simply abolish the existing corporate income tax system. Currently, this tax is paid only on the portion of the profit that the shareholders’ meeting decides to distribute as dividends to the shareholders. Instead, it has been proposed to levy a profit tax as it was before the 2018 tax reform — when it had to be paid regardless of whether dividends were distributed or not”, explains Sultanova. She points out that detailed discussions will be possible once the relevant bill gains the majority support in the Saeima. “The desire of the Latvian and Lithuanian governments to take additional money from the financial sector, just because commercial banks have truly outstanding indicators this year, is adventurous. Nobody can predict whether the same performance will also be there in 2024 and subsequent years. Moreover, this will not encourage banks to issue new loans to businesses and private individuals. There’s also a risk that they will simply pass this additional tax on to consumers — citizens and businesses — by simply raising their service rates”, says Sultanova of the possible consequences. She draws attention to the fact that in Estonia, at least for now, there are no plans to introduce an excess profit tax for the financial sector, and thus banks in this country might feel differently than their competitors in Latvia or Lithuania. She highlights the fact that in Estonia, there was resistance to the notion of introducing an additional tax. However, the emphasis shifted towards encouraging banks to disburse larger dividends, which naturally leads to increased corporate income tax payments.

Credit ceiling limits

The BDO study indicates that various countries, including those in the Baltic region, have implemented debt-to-income and debt service-to-income ratios. These measures are designed to protect borrowers while also providing greater security for lenders. Sultanova notes that in Lithuania, the monthly mortgage payments should not surpass 40% of a borrower’s net monthly income. In Estonia, this threshold is set at 50% of the borrower’s monthly net income. In Latvia, meanwhile, the debt service level is confined to 40% of the borrower’s monthly net income with a slight margin for flexibility, and the debt-to-income ratio is limited to six times the borrower’s annual income, again with a small margin. “These thresholds are somewhat similar”, Sultanova observes. She adds that in other countries, particularly those with stronger economies in Europe, the approach varies slightly. For example, the Netherlands enforces strict limitations based on income brackets. A person earning under €30,000 annually is allowed to allocate approximately 30% of their income to mortgage repayments. Conversely, for someone earning around €60,000, this proportion can exceed 50%. In Belgium, the monthly mortgage expenses must not exceed 50% of the borrower’s net monthly income. In Ireland, individuals have the option to borrow up to 3.5 times their gross income. While there are no specific limits regarding the proportion of loan repayment in relation to the borrower’s monthly or annual income, lenders will evaluate the affordability of the monthly repayments. “Sweden has a system in place where lenders assess the borrower’s capacity to cope with a 7-percentage point increase in interest rates”, explains Sultanova, sharing her insights from international practices. She also points out that, in France, since the summer of 2021, the French High Council for Financial Stability has set a guideline for the debt service-to-income ratio, capping it at 35%. As Sultanova underlined, “the imposition of excess profit taxes on the financial sector could significantly alter the credit environment.” Rate hikes traditionally take time to influence the broader economy, būt higher tax burdens could lead to immediate changes in banks’ lending behaviours. Sultanova highlighted that with such taxes, banks might become more reticent in issuing new loans, opting either to curtail the number of loans offered or to heighten the criteria for loan approvals. “This echoes the situation in Hungary, where a substantial bank tax introduced in 2010, as per a European Commission report, resulted in decreased bank lending as financial institutions strove to preserve their profitability.” Sultanova further underlined that the Japanese case from 2000-2002, known as the Ishihara tax, provides an illustrative precedent. “When banks reduced credit supply in response to the tax, corporate borrowers faced significant hurdles in accessing credit.” While larger corporations might pivot to bond financing or seek credit from other banks or financial markets, this shift underscores the broader impact such taxes can have on credit availability. As Sultanova cautioned, “these dynamics could potentially ripple across the financial sector, influencing both the availability and the cost of credit for businesses and individuals alike.”