Economix: Could Tax Reform Make the Financial System Safer?

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

In the deafening cacophony of voices in Washington on the debt ceiling, it is easy to miss a potentially more significant development. There is growing bipartisan interest in tax reform, including changing the corporate tax system to make it more sensible and a bulwark against financial sector instability.

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The House Ways and Means Committee and the Senate Finance Committee held a joint hearing last week — the first time these two committees had met in this fashion to discuss taxation in more than 70 years, their chairmen said. The theme of the hearing, “Tax Reform and the Tax Treatment of Debt and Equity,” might sound dry, but in fact it was well designed to carve out some space for agreement across the political spectrum.

The basic question at the hearing was: Did the tax code contribute to the severity of the financial crisis in 2008-9? At one level the answer is a simple yes, because the tax deductibility of interest payments encourages families to take out bigger mortgages and companies to borrow more relative to their equity capital. (Dividend payments to stockholders are not tax deductible.)

But where in the tax code should we focus attention if the goal is to prevent similar crises in the future?

I testified at the hearing and argued that banks and other financial institutions should be the priority, because their overborrowing was central to past crises and is likely to be a salient issue in the future. It is also ironic — perhaps even bizarre — that while we try to constrain how much banks borrow through regulation, we give them strong incentives to borrow more through the tax code.

This “debt bias” is covered in detail by two very good Joint Committee on Taxation reports that were released at the hearing, one on business debt and one on household debt. (This committee comprises a subset of members from the Ways and Means and Finance Committees; on these technical issues it makes sense to get as many legislators as possible on the same page.)

One goal is “tax neutrality,” meaning that from a tax perspective it would be equally attractive to raise capital through issuing debt or through issuing equity. This could be done by limiting the tax deduction on interest payments or creating an equivalent type of deduction for dividends. In other words, you could raise more or less revenue with such a change, but the debt bias can be addressed.

I proposed that we go further and consider a tax on “excess leverage” in the financial sector. The idea — already being applied by some European countries and further developed by some of my former colleagues at the International Monetary Fund — is based on the premise that a high level of borrowing relative to equity is a form of pollution, creating negative spillovers for the rest of the economy.

When any entity in the financial system has little equity relative to its debts, it has moved closer to becoming insolvent. We need big banks, in particular, to have strong loss-absorbing buffers, and that is the role played by equity capital. But the same logic applies to insurance companies, hedge funds and even leveraged buyout firms.

When anyone has a great deal of leverage, this amplifies the upside return on equity — for a given return on assets, equity holders get more. It also amplifies the downside returns. And executives do not generally pay sufficient concern to the effects of their firm’s potential bankruptcy on the rest of the financial system.

One way to structure this approach would be as a “thin capitalization” tax — so companies of any kind would be taxed on debts that exceeded some reasonable multiple of their equity (perhaps a multiple of three or four).

We tax pollutants to discourage their production in other parts of the economy. Sometimes we use regulation, as in limits on auto or power-plant emissions. But in banking we limit leverage (debt relative to equity) through regulation while encouraging leverage through the tax code. This makes no sense.

The revenue from the excess leverage tax or thin capitalization tax could be used to help pay for broader tax reductions for the nonfinancial corporate sector.

When banks implode, a big part of the costs are imposed on nonfinancial companies, their employees and their investors. The companies lose access to credit, their customers become reluctant to buy and so on. The fiscal costs of a major bank-induced recession are also huge: the 2008-9 episode will end up increasing our ratio of government debt to gross domestic product by more than 40 percent.

For 2018, the Congressional Budget Office estimates that we will have more than $8.5 trillion in government debt as a direct result of the crisis (the details are in my testimony).

Either taxes will be increased or productive government spending will be decreased, or both, as a result of the crisis, with a direct negative impact on the nonbank part of the economy.

Why not give everyone a tax break, financed by taxing the pollution generated by banks? At the very least, the prospect of such a break should encourage powerful corporate lobbies to reflect on whether American banks should continue to get their unnecessarily favorable tax treatment.

Article source: http://feeds.nytimes.com/click.phdo?i=5a4a7dc5b045ccb7e8601da6aa54cee0