Could Tax Reform Help Make the Financial System Safer?

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.

38 thoughts on “Could Tax Reform Help Make the Financial System Safer?”

  1. This comment is not related to Professor Johnson’s post, and I hope Simon will forgive me for that. I think this also is something related to legislation people should be made aware of.
    http://moran.senate.gov/public/index.cfm/news-releases?ID=d4fb7a19-5e1e-404c-836c-01dd5229ab4e

    It looks like Senator Jerry Moran is doing Dick Shelby’s dirty work for him. Maybe Dick Shelby is afraid it’s becoming way too obvious to all of America that he is the lapdog of the large banks, so he is asking Moran to put his name on his dirty-work for him. I guess Dick never knows when the illiterates of Alabama might wake-up to the fact Shelby passes laws which help large banks abuse the poor of his own state, so he got Senator Moran to sign his soul over to the TBTF bankers.

    If you live in Kansas and are a farmer tired of bankers dictating your lives, you might want to call Jerry Moran and tell him you do not appreciate him putting his name on (or passing) this bill. Or if you are any person who got suckered into ARMs loans which 99% of the time only benefit the bankers, you might call Moran and tell him you think a strong CFPB would be a good thing. Or you might just show Moran you don’t like the attempted killing of Consumer protections against predatory loans and illegal foreclosures by checking his opponent’s name in the next election.

    The best way is to call Jerry Moran’s Washington D.C. office during Eastern standard time work hours:
    Make sure to tell the operator, “I want to talk to Senator Jerry Moran.” Phone: (202) 224-6521

  2. Dr. Johnson, your proposal of a “thin capitalization tax” seems imminently reasonable. It would have been a good band-aid on a minor cut. Now that we (the people) are suffering from a great, gaping chest wound, it hardly seems sufficient to the task of stopping the bleeding, let alone repairing the damage. It’s perfectly evident that the nature of the trauma has not reached the rarified policy circles of the East Coast, but it will, Dr. Johnson, it will.

  4. Here is a copy of the legislation to castrate the CFPB. (No doubt co-written by Dick Shelby and the American Banker’s Association ). http://moran.senate.gov/public/index.cfm/files/serve?File_id=218932db-e936-4b7f-9ae2-1bb34e3e692e

    For those who don’t have time to follow these issues, the Moran Bill would castrate the CFPB by appointing a 5 person commission and not one director to lead the CFPB. Republicans can get some banker lapdogs in there like the old director of the O.C.C. (Office of Comptroller of the Currency) John C. Dugan, or even John Walsh who has been coddling the loan servicers. With a Commission you only need 1 or 2 Banker backed members, and the entire agency becomes a joke. Which is the way Senator Dick Shelby, the American Bankers Association, and Republicans in general want it.

    John C. Dugan was such a brown-noser for the large banks, he’ll probably still be trying to wash some brown goop off his tongue as he enters hospice. We do not need even one Republican appointed John C. Dugan to ruin the CFPB.

    Call Senator Moran this week and tell him you do not support the legislation to kill the CFPB:
    Make sure to tell the operator, “I want to talk to Senator Jerry Moran.”
    Phone: (202) 224-6521

  6. @Moses: CFPB was dead in the water when it became clear months ago that Obama would not grow a pair and appoint Warren.

    Also, in my opinion, comments that do respond to the blog post, or AT LEAST to comments on the specific post, should be deleted by the administrator.

  7. I really admire Simon’s focus (does he have any pit-bull in his family history?) on big institutions that wield the most political power and benefit most from “privatize the profits and socialize the losses” policies. But since these are only nominally under US jurisdiction I was hoping for a bit more on how international aspects of favoring equity over debt would be accomplished, and maybe some comment on how the big players might attempt to pervert or dodge the proposed changes.

    Too bad the administration didn’t jump immediately from health care to tax reform. People like Grover Norquist understand that our tax system is the biggest underminer of government legitimacy, so they fight to keep it Byzantine. A constitutional amendment for a balanced budget is flat-out crazy, but how about a constitutional amendment for a flat tax, a VAT, and all subsidies provided in cash rather than tax breaks? “The tax code of the US shall not exceed 140 characters.” That would be a Twitter revolution indeed.

  8. Treasure Islands: Tax Havens and the Men Who Stole the World [Paperback]
    Nicholas Shaxson (Author)

  9. Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens [Hardcover]
    Nicholas Shaxson (Author)

    (just reading the editorial reviews on this edition page is worth the look and see time)

  10. And still more from this source:

    Treasure Islands: Tax Havens and the Men Who Stole the World [Paperback]
    Nicholas Shaxson (Author)
    See all reviews (5 customer reviews)

    also look inside:

  13. Everybody start drumming up support for the Kucinich bill, which, by the way, the responsible political party, the Green Party, has endorsed into their plank, the Monetary Reform Act, or taking back our money system from the FRB and the privately owned, debt creating banking system, which is systemically and corruptly rotten.

  14. the tax on leverage already exists. the FDIC changed the formula for its levy from one on deposits to one on total liabilities. this levy is progressive based on FDIC’s assessment of the institution’s risk. perhaps it is too low or the progressiveness should be more explicit on leverage (leverage is one component of FDIC’s risk rating)

  15. Drunk with power is the phrase that comes to mind – anyone still wanting their future in the hands of drunks?

    Here’s the plan today,

    “A Super Congress would be less accountable than the system that exists today, and would find it easier to strip the public of popular benefits. Negotiators are currently considering cutting the mortgage deduction and tax credits for retirement savings, for instance, extremely popular policies that would be difficult to slice up using the traditional legislative process.”

  16. Ideas on how to make the tax code better for the country and the whole of its population are interesting. But in the final analysis all that matters, regardless of the spin, is what is in the best interests of the plutocracy. That should be perfectly clear by now. Let’s quit pretending that we have a democracy and that what matters to the bottom 95 percent of the population, based on wealth and income, matters to those who make our laws.

  17. @ doncastro So you want to take pretension and fiction out of the tax code? What a radical notion.

    “…many fictitious aspects of the economy today, fictitious incomes, costs, capital, savings, statistics, theories and ideologies. What do you mean by fictitious?”

    “MH: Something that’s unreal, something that’s pretend, for instance pretend earnings of companies that really aren’t earned, or pretended values for mortgages that were given by Wall Street banks, and their affiliates when there’s no underlying value there, or fictitious costs. Most economic theory today justifies fictitious costs, for example the Federal Reserve came up with a method of assessing land values that almost seems to come up negative in some years, because it treats buildings as steadily rising in value as their reproduction costs grow, leaving land as a residual, this understating the value of land and overstating the value of buildings.”

    “…if you’re wealthy in today’s economy, you don’t make any money at all, because it’s all a (tax deductible) cost…”

    “The tax code is fictitious, because real estate owners have been permitted for the last half century to pretend that buildings are losing value very rapidly, so they can take so much off for building depreciation that they pay no income taxes at all, as it works out. The fact is, buildings don’t lose value if they are well-maintained with normal maintenance and repair. If landlords don’t do this either they’re brought to court for violating the residential building laws, or they break the commercial lease. Right down to the seemingly empirical statistics and theory, the whole economy is based on a kind of parallel universe, a what-if world of assumptions designed to show that the wealthiest people don’t have any income at all.”

    “In fact if you’re wealthy in today’s economy, you don’t make any money at all, because it’s all a (tax deductible) cost. Corporations don’t seem to make any money because they seem to have everything as an expense. For instance interest payments are the largest item that the IRS permits corporations to take off as an expense of doing business. But it’s not an expense of doing business at all, it’s a function of what outside raiders and corporate junk bond holders have paid to buy up the company, and instead of doing business, they’re carving them (companies) up, closing them down, stopping their long term research and other projects, and doing just the opposite of what’s needed for an industrial economy. That’s why the book deals primarily with what the financial sector, which is not part of the economy at all, nor is the property sector part of the economy. They are a completely separate consumption process, more in the character of a parasite, than of (producing) actual goods and services….”

    http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=103×371420

  18. you mind as well give a lecture to a group of vampires imploring them to take up sunbathing, as to hope this bunch, can get us out of the whole this bunch willing, and profitably, for them, drove us into. The fix is in SJ, the time to expect the status quo to do anything about the status quo is past. New solutions will have be created. But not the bunch in DC. It is up to the people now, pitchforks time, (metaphorically speaking, for now). We’ll see if the people are up to the task. I doubt it…but what the hell.

  19. What about considering a large reform to the corporate tax code: make dividend payments tax deductible but tax dividends as ordinary income for institutions and individuals. This could have a positive effect by decreasing the preferential treatment of debt while also decreasing the agency costs of free cash flow by encouraging dividends. Thoughts?

    The system would have to be tested to make sure that the tax on dividends makes up for the lost corporate taxes, but a proper model could be determined through experimental investigation.

  20. “What about considering a large reform to the corporate tax code: make dividend payments tax deductible but tax dividends as ordinary income for institutions and individuals. This could have a positive effect by decreasing the preferential treatment of debt while also decreasing the agency costs of free cash flow by encouraging dividends. Thoughts?”

    This sounds great for about three years ago. Now? Too little, and WAY too late.

  21. Many of the suggestions re: corporate tax changes are interesting, but until someone figures out some methodology of converting huge income statement profits into corporate income tax on the return, all of the ideas presented thus far, won’t be effective, or meaningful.

    When corporations with massive profits are essentially not paying income tax, the entire theory of taxing these entities at the corporate level, in my estimation, need to be completely revamped. The tax structure imposed isn’t carrying out its’ designed purpose, which is to generate revenue(s) for the central government.

    You can tinker away until the cow jumps over the moon, but at the end of the day, some lawyer or CPA will formulate a strategy to defeat whatever statute you care to consider, and if its’ overturned by the tax authorities, the added costs are just one more expense of doing business. In the meanwhile, you may have over time saved the company a fortune in income tax expense.

  22. There is an odious, discriminating, regressive, absolutely non-transparent, and completely arbitrary regulatory tax, which is levied on those perceived as “risky”. “Experts” like Simon Johnson either ignore it or are just not aware of it.

    Since banks are basically not required to have any capital at all when lending to a sovereign like the US, or very little capital when lending to those rated AAA and perceived as not risky, it should be clear that most of the required bank capital in the whole bank system, is unfairly shouldered by those perceived as “risky”, like the small businesses and entrepreneurs.

    If there is one single “tax-reform” needed in the financial sector, this is the one… to get rid of the regulatory discrimination based on perceived risk of default, and which is so senseless because the perceived risk of default is cleared by the markets by through the risk-adjustment of the interest rate.

    By the way, though I am glad Simon Johnson is in this post finally showing some signs of awakening to the real problems in the financial sector, I do not understand his keen support for a progressive tax on leverage, when it is so much easier and so much transparent to just limit the leverage.

  23. “Singing Around the Campfire says The tax structure imposed isn’t carrying out its’ designed purpose, which is to generate revenue(s) for the central government.”

    You may be worong as the tax code is to pay for debt created by fractional banking and debt currency, which created corporations to avoid tax.

  24. @beene “You may be worong as the tax code is to pay for debt created by fractional banking and debt currency, which created corporations to avoid tax.”

    And we’re back to the same question about all the “problem solvers” – which is worse?

    That they DON’T know and are making decision for millions of living breathing people and the future

    or that they DO know and say stuff like “poor people can pay more taxes than they are now”

    Hatch and Utah – “god’s county”…

  25. @ Beene, what you said and what “I” said, are not necessarily mutually exclusive propositions, I don’t think.

  26. @ Annie, helluva guy, isn’t he? And to think Teddy Kennedy somehow regarded this fella a friend?

    It’s clear to me: the top-tier gets a free ride, and the increasingly serfdom-remainders get to pay the freight, and better keep that smile on your face, or else.

    It’s gone horribly bad and twisted beyond perversion, greed, or immorality…..now prepare to descend into the lower reaches. Everything says it’s so.

  28. Why not give everyone a tax break, financed by taxing the pollution generated by banks?

    Ha Ha Simon boy!!. You were invited to talk about tax reform. Not to promote your conspracy theories. Please respect the time of the people of the united states!

    Bozo the clown sounds more credible than you.

  29. Ditsy Girl — Doing the Devil’s Work is more apt. Drs. Johnson and Kwak have a great sense of humor to tolerate you, obviously. Say hi to Timmy.

  31. @Singing Around the Campfire – “It’s gone horribly bad and twisted beyond perversion, greed, or immorality…..now prepare to descend into the lower reaches. Everything says it’s so.”

    Reminds me of that Pink Floyd song – ….”so you think you can tell heaven from hell…”

    It’s really a much more simple problem – they’re not qualified to do “god’s work”.

    The *real* God knew all we could handle was figuring out how planting the seed would keep us alive :-)

    Too busy to find that news clip about how a neighbor – a babushka busybody – got the local government to come down on a neighbor who was growing food in her front yard (she was *freely* educating the little kids in the neighborhood during summer break – horrors) to move the planters to the backyard….growing veggies in the front yard in suburbia is offensive, but YEARS of discussion about torture is not….

  32. @ Annie, exactly. Local gov officials were all over that lady, like white on rice, and it’s truly sickening.

    She is now being royally harassed by clowns that need to be trotted before a criminal court, and tried for criminal harassment.

    While those other ego-maniacs are certainly not qualified to do anything but destroy God’s work, they’re now escaping with impunity for serious crimes against humanity, and their media is furiously at work, directing attention elsewhere. As usual.

  33. It is very well known that taxation is a tool that can be used for “social and economic engineering”, and in that case I have to agree that it can in fact be be used to remove certain “risks” from the financial system in order to make it safer. The powers that be need to get more creative with taxation.

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  36. “so firms of any kind would be taxed on debts that exceeded some reasonable multiple of their equity (like 3 times or 4 times).”

    This would be an administrative nightmare and would put immense pressure on accounting systems that they aren’t designed to handle.

  38. why and precisely whaT was the mechanism that pronounced Obama as a Nobel Peace Prize recipient? No one seems to dare ask how this atrocity came about: No one questions the “Chicago Schools” (heavy financial funding beyond all reason for the economic department) and its own uncanny luck with the corrupted streak of the hy-bred bank financed award versions either. And no one questions Obama’s background any more as child in the land of the CIA massacres of Indochina (…just boy hood training…), nor do people see Daly and Chicago power politics settling into and entrenching the National Capital city with its stench…as part of the Obama team stream. Just keep your eyes on the money now, but maybe instead of temper tantrums over Wall Street Greed and Corporate syndicalism we might all start a new realistic chant: that might just make a real difference in “real: history:

    NOW!!! ELIZABETH WARREN
    http://en.wikipedia.org/wiki/Elizabeth_Warren
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    …………………………………………….for President YES, FINALLY; AN HONEST PRESIDENT!

    NOW!!! ELIZABETH WARREN
    http://en.wikipedia.org/wiki/Elizabeth_Warren
    …………………………………………….for President… BUT OF COURSE, SHE KNOWS WHERE TO FIX THINGS AND WHO TO KICK OUT OF THERE!

    NOW!!! ELIZABETH WARREN
    http://en.wikipedia.org/wiki/Elizabeth_Warren
    …………………………………………….for President …THINK OF THE GREAT MINDS IN THIS COUNTRY SHE WILL ENDOW WITH POWER AROUND HER!

    A REAL PEOPLE’S CHOICE!

    NOW!!! ELIZABETH WARREN
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    LET’S HEAR IT ACROSS THE COUNTRY!

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