Cyprus's wealth tax makes perfect sense – its rich won't escape unscathed

Ignore the hysterical reaction to the tax on Cypriots' bank deposits. This is a practical, fair solution to a complex problem
Cypriot President Nicos Anastasiades (C) arrives at the parliament in Nicosia
Cypriot President Nicos Anastasiades (C) arrives at the parliament in Nicosia Photograph: Stringer/Reuters

There are several principles at stake in the row over Cyprus and its bailout. But one we should ignore is the hysterical reaction to a tax on bank deposits. It is a wealth tax – and about time too.

Vladimir Putin is outraged and so are all Europe's banks. Writing in the Financial Times, Mohamed El-Erian (paywall), the chief executive bond fund manager of Pimco, represents the widely held view that it is the thin end of the wedge. What next? Spaniards will worry that a bailout, which many believe inevitable, will come with a current account surcharge attached.

But Cyprus is a special case. It is entirely and completely bankrupt. It has strung out negotiations with Brussels and the IMF for months. It has taken those negotiations to the brink with an insistence that it receive the same treatment as Ireland and Portugal. They received loans and were allowed, mostly, to determine how they repaid.

Giving loans to Cyprus presumes that the country has the capacity to repay. It should do, but it doesn't. It has one of the highest per capita GDP ratios in the Mediterranean. It is a huge centre for ship management, and a haven for English and Russian tourists. And it has developed a huge financial centre relative to its size.

Yet there is a suspicion that much of the funds in the country are only there if this tax haven remains just that. And like Greece, corruption is a factor.

So any long-term effort to repay EU loans will be left to ordinary people while the rich take flight. Russians, who account for a large slug of the economic activity, will take their tourism to Turkey and decamp their funds to Latvia. So a direct tax is necessary. It could take the form of a cut on incomes. That is the policy pursued in Ireland and Portugal, where public sector workers took the hit. But the Cyprus per capita income figure hides huge disparities. Again, the rich would hide and the poor would pay.

A wealth tax on bank deposits, where most wealth is held, is consequently a practical solution that also fulfils a basic economic need, which is to shift taxes away from income to wealth. Poorer citizens need to feed themselves, and a tax on incomes, especially for those with no savings, is the worst outcome.

The IMF, our own Institute for Fiscal Studies, and Paris-based thinktank the OECD, have argued that governments need to switch away from taxes on incomes, which act as a disincentive to work, to taxes on wealth. They sensibly target land. Unfortunately, a tax on land takes time, which under the current rules, Cyprus doesn't have.

There was a route to avoid this debacle. The EU, after the financial crash, should have agreed to forgive much of the debts, not just in Cyprus, but also Ireland et al. The Germans, who are blocking debt forgiveness with the Finns, the Dutch and the Austrians, would have been repaid in full from economic growth over the past three years. Instead they face a prolonged depression and growing resentment from southern Europe towards their hardline policies.

To offset some of the burden, the EU should also exclude the smallest savings deposits from the tax. But given the constraints, it is easy to see why the Cypriot government was ambushed, and why a wealth tax became a key element of the package.