Rethinking the Distortions of Banking Move over, Robin Hood tax. Make way for the FAT tax and the hot money levy. A European Union plan to add a charge to financial transactions - popularly known as a Robin Hood tax because it would take money from banks and in some versions give it to the world's poor - is dying. That is a good thing. The idea was taken up by the Occupy movement as well as by luminaries like Bill Gates, but it never made economic sense. Taxing transactions would not have dealt with the causes of the financial crisis, like too much leverage and too much reliance on hot money. It would just have driven business offshore. From the start, Britain opposed the tax, which means it had no chance of being adopted by the European Union as a whole. Now the Netherlands has come out against it, so it cannot even be applied across the euro zone. With the German finance minister, Wolfgang Schäuble, saying that the "smallest thinkable unit" for the tax is the euro zone, it is only a matter of time before the Robin Hood tax is buried. E.U. finance ministers will discuss alternative ways of taxing the financial sector this week at a meeting in Copenhagen. The guiding principles should be to rein in excessive risk-taking and to remove distortions that bias one form of economic activity over another. With these ideas in mind, there are three specific things Europe, and for that matter the rest of the world, should do. First, countries should impose a so-called hot money tax on banks. Such a charge would apply to a bank's wholesale borrowing. Ideally, short-term wholesale money should face an especially high tax, because excessive reliance on such easy-come-easy-go financing was one of the reasons companies like Royal Bank of Scotland and Lehman Brothers failed. A hot money tax would encourage banks to raise longer-term money or to attract relatively stable retail deposits. It would also mean that if governments had to bail out banks in the future, the industry would at least have paid toward its own rescue. So far, 11 of the 27 members of the European Union - including Britain, France and Germany - have imposed such a tax, according to KPMG. The rest of the Union members should follow suit, as should the United States, which has been toying with what the administration of President Barack Obama calls a Financial Crisis Responsibility Fee. Although it is unlikely that anything will be done on this front before the U.S. presidential election in November, a hot money tax could eventually help the United States reduce its deficit. Second, countries should remove the tax system's bias in favor of debt. In most places, companies can deduct interest payments from profit before they pay corporate taxes. This encourages firms to leverage themselves heavily. The whole economy, not just the banking sector, is affected, but lenders are doubly exposed. Not only do they have an incentive to pile on the leverage themselves, they are periodically exposed to overindebted customers, especially real estate developers and leveraged buyout houses. Third, financial services should no longer be exempt from value-added taxes. VAT is a consumption tax applied at each stage in the chain of production. Companies add VAT to what they sell to other firms, but get a credit for what they purchase. This means that, ultimately, only the final customer pays the tax. But in the European Union and other jurisdictions, banks are exempt. They neither apply VAT to the services they provide customers nor do they get credit for the VAT they pay on their purchases. This anomaly causes several distortions. Final customers are undercharged for financial services, meaning that they consume too much of them. Business customers, by contrast, are overcharged, as there is no VAT they can reclaim on what they pay banks. Meanwhile, lenders have an incentive to perform activities internally that would be more efficiently done by other companies because they cannot recover the VAT they would pay to outside companies. The VAT exemption probably also costs governments income. No proper calculations have been done, but a tentative estimate for the United Kingdom puts the lost revenue at £10 billion, or $15.87 billion, a year, according to the Mirrlees Review for last year, which is published by the Institute for Fiscal Studies. Given all these problems, it might seem hard to believe that financial services are exempt from VAT. But there is an explanation. Banks do not charge fees for most of their services. Instead, they make the bulk of their income from the spread between the interest they charge for loans and what they pay depositors. Dividing up this spread among specific customers so that VAT can be applied to every bill would be tricky. There are, broadly speaking, two solutions. One is to work through the technical complexities. The other is to introduce a financial activity tax, or FAT tax. This is applied to a bank's earnings and to the compensation it pays employees, on the theory that the sum of these two is another way of measuring value added. The FAT tax has potential populist appeal, and not just because of its name. After all, in the current environment, who would object to taxing bankers" pay and bank profits? One wrinkle would need to be ironed out, however: there would need to be a way to give business consumers a FAT tax credit. There is no disguising the fact that it would be complicated to revamp the way that banks are taxed. But given the havoc they caused in the recent financial crisis, the fact that the sector is undertaxed and the way in which the current system distorts economic activity, it is well worth the effort. The near death of the Robin Hood tax provides a golden opportunity to do so. Hugo Dixon is the founder and editor of Reuters Breakingviews.