With growing demands that governments must increase taxes on the rich, the so-called one per cent, there's a strong possibility that some participants at the upcoming G20 finance ministers meeting in Washington will take aim at the banks with renewed calls for new taxes.

Canadian Finance Minister Jim Flaherty has so far opposed additional bank taxes on the grounds that Canadian banks didn't need government bailouts in the last financial crisis. Yet ironically, Canada already has a bank tax in place.

Prior to 2008, the federal government applied capital taxes to large financial institutions in addition to income taxes. The capital tax was levied on the existing capital stock (debt and equity) of a bank or insurance company. Financial institutions are now allowed to offset their capital tax payable by the income tax they paid in the current fiscal year, and a prescribed number of previous and future years. Financial institutions have been sufficiently profitable in recent years to make the existing capital tax essentially a non-issue.

The change to the capital tax regime was good policy. Capital taxes rank dead last in terms of efficiency behind corporate income taxes, personal income taxes, and consumption taxes. In other words, the tax is the worst possible type in terms of a negative impact on capital investment, productivity, and economic growth. A 2002 Fraser Institute study described capital taxes as "Canada's most damaging tax." Since the study was published, there has been a shift away from capital taxes.

However, in addition to the remaining federal capital tax, some provinces still have a capital tax on financial institutions. For instance, Ontario applies a capital tax, known as the SAT, on life insurers.

Although large financial institutions have been able to successfully offset capital taxes through the income tax they have paid, there are reasons why capital taxes may become binding in the future.

Profitability will likely be eroded by new regulatory requirements. For instance, banks will be required to hold more regulatory capital through the implementation of Basel III, an international agreement by solvency regulators that covers regulatory capital standards. In addition to downward pressure on bank returns on capital, this will result in banks holding more capital subject to a capital tax. A further reason why capital taxes could become binding is that corporate tax rates have declined while the capital tax rate has remained fixed at 1.25 per cent.

Following the last financial crisis, authorities globally have been paying more attention to systemic risk. This is the risk that problems at one institution could adversely affect the financial sector as a whole and the broader economy. For regulated financial institutions such as banks, capital taxes are particularly harmful from a solvency perspective because they result in a deterioration of capital, even when an institution is losing money. Capital serves as a buffer against unexpected losses thus reducing the risk of insolvency. The worst time for the federal capital tax to become binding is right after one, or more major financial institutions experience severe losses resulting in a significant loss to its capital as the tax will erode capital even further.

"It's counterproductive to tax financial institutions and reduce their capital by taxing them when the issue is capitalization and liquidity," Flaherty told the news media.

Flaherty is absolutely right. And he should follow up on this logic by phasing out the remaining capital tax on large financial institutions.