By Simon Johnson. My written testimony to the joint hearing of the House Ways and Means Committee with the Senate Finance Committee is here.
In the deafening cacophony of Washington-based voices 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.
The House Ways and Means Committee and Senate Finance Committee held a joint hearing last week – apparently the first time these two committees have met in this fashion to discuss tax in over 70 years. The theme of the hearing might sound a little dry, “Tax Reform and the Tax Treatment of Debt and Equity,” but in fact it was well-designed to carve out some space for future agreement across the political spectrum.
The basic premise of the hearing was the question: Did the tax code contribute to the severity of the financial crisis in 2008-09? At one level the answer is 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 (as dividend payments to stock owners are not tax deductible). But where within the tax code should we focus attention, if the goal is preventing similar crises in the future?
I testified at the hearing – my testimony is here – and I 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 – or perhaps even bizarre – that while we try to constrain how much banks borrow through regulation, we also give them strong incentives to borrow more through the tax code.
This “debt bias” in the tax code is not controversial; it is covered in detail by two very good Joint Committee on Taxation (JCT) reports that were released at the hearing. (The JCT comprises a subset of members from the House Ways and Means and Senate Finance Committees; on these technical issues it makes sense to get as many legislators as possible on the same page with regard to what is in the existing tax code.)
One goal would be aim for “tax neutrality”, meaning that – from a tax perspective – it would be equally attractive to raise capital through issuing debt and 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 revenue with a reform or less, but the debt-bias can definitely be addressed.
I actually proposed that we go further and consider a tax on “excess leverage” in the financial sector. The idea – which is already being applied by some European countries and further developed by some of my former colleagues at the International Monetary Fund – is that a high level of borrowing relative to equity creates a form of “pollution,” in sense that it creates negative spillovers for the rest of the economy.
When any entity in the financial system has little equity relative to its debts, it is closer to becoming insolvent. We need big banks in particular to have strong loss-absorbing buffers; this is the role played by equity capital. But same logic also applies to insurance companies, hedge funds, and even leveraged-buyouts.
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. But is also amplifies the downside returns. And no executives ever pay sufficient concern to the effects of their firm’s potential bankruptcy on the rest of the financial system.
One way to structure this would be as a “thin capitalization” tax – so firms of any kind would be taxed on debts that exceeded some reasonable multiple of their equity (like 3 times or 4 times).
We tax pollutants, to discourage their production in other parts of the economy. Sometimes we use regulation also, e.g., for auto or power plant emissions. But in banking we limit leverage (debt relative to equity) through regulation while also encouraging leverage through the tax code. This self-contradictory structure makes no sense.
And 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 firms, their employees, and their investors – these firms 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 2008-09 episode will end up increasing our government debt-to-GDP ratio by over 40 percent. For 2018, the Congressional Budget Office estimates that we will have over $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.
An edited version of this blog post appeared on the NYT.com’s Economix blog. It is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.