I only allow for a partial offset relative to what the Modigliani Miller theorem implies – in fact I assume the offset is only 30% as great, which means that the weighted average cost of cost of capital rises by 70% of the baseline 10. Making this adjustment reduces the estimated present value of the cost of permanently higher bank capital by about 1% of annual GDP – from just over 4% to 3%. The major part of this remaining cost reflects that fact that we assume that all interest paid by banks on debt they raise is tax deductible at the corporation tax rate (of 28%) while equity capital has to earn the required rate of return out of post tax profits. But in thinking about the wider economic impact of a switch to less tax sheltered funding for banks we need to take account of the extra revenue generated for the government. The government could use the extra tax revenue it gets from banks to shelter the users of bank loans from any knock on impact on their cost of raising finance. This seems a natural assumption to make. And it would mean that we should reduce the estimated negative impact on economic activity.
Competition-weighted exchange rate, TCW index Index, 1992-11-18 = 100 150  150  145  145  140  140  135  135  130  130  125  125  120  120 00  01  02  03  04  05  06  07  08  09  10  11  Note: Outcomes are current rates to 081201 and the forecasts are quarterly averages. Broken line is the Riksbank’s forecast. Source: The Riksbank  14  BIS Review 154/2008  Figure 13. Labour costs, labour productivity and CPI in Sweden and the euro area Average of annual percentage change 2000-2008 4,0  4,0  3,5  3,5 Sweden  Euro area  3,0  3,0  2,5  2,5  2,0  2,0  1,5  1,5  1,0  1,0  0,5  0,5 0,0  0,0 Labour cost index  Productivity  CPI  Source: Eurostat  BIS Review 154/2008  15