Tax Notes on September 29, 2008.
At the core of the current financial crisis is excess leverage. There has been no shortage of explanations for this unhappy turn of events: lax regulation, financial innovation, loose monetary policy, imprudent lending, and greed. But one cause has gone unmentioned: our tax laws.
Two features of the U.S. tax system have encouraged the types of borrowing that played a prominent role in the credit meltdown. The first is deductibility of mortgage interest. Wall Street financiers tapped into this huge reservoir of tax benefits to fuel an explosion of mortgage indebtedness. From 1995 through 2007, mortgage debt as a percentage of GDP increased from 47 percent to 81 percent. (See Figure 1.) Home equity loans have grown particularly quickly, from 3.2 percent to 8.2 percent of GDP.
The second pro-leverage provision in the tax code is the deductibility of interest by corporations. At a time when we need more stability, tax rules promote financial instability by favoring debt over equity. The five major U.S. investment banks still in existence at the beginning of this year — all corporations taxed at the statutory 35 percent rate — had leverage ratios that spiked in 2007. All had leverage ratios in 2007 higher than in any other year since 2000. (See Figure 2.)
Despite the problems caused by excess debt, Americans are adamantly opposed to anything more than minor restrictions on interest deductibility. Politicians, the real estate lobby, and homeowners consider mortgage interest deductions to be as American as apple pie. And deducting interest expense is the bread and butter of tax planning for business. But none of this changes the hard reality that deductions for mortgage interest and for interest costs of corporations encourage borrowing even when that borrowing threatens financial distress and bankruptcy.
Figure 1. Ratio Mortgage Debt to GDP in the United States,
Sources: U.S. Department of Commerce, Bureau of Economic
Analysis, National Income and Product Accounts, Table 1.15. "Gross
Domestic Product," available at http://www.bea.gov; and Board
of Governors of the Federal Reserve System, Flow of Fund Accounts
of the United States, September 18, 2008, Table 1.217, "Total
Mortgages," line 2, available at
In contrast to popular complacency, economists have been warning about the unholy relationship between debt and income taxes for decades.
For example, in 2005, after a year of deliberation, the President's Advisory Panel on Federal Tax Reform recommended — as have other tax reformers for decades — limiting tax breaks for mortgage interest. In particular, the panel, chaired by former Republican Sen. Connie Mack, wanted to reduce the amount of mortgage interest eligible for tax relief, disallow benefits entirely for interest on home equity loans, and more fairly distribute the tax benefit by converting the deduction to a tax credit.
On the macroeconomic level, tax incentives for mortgage debt shift the economy's limited capital from productivity-enhancing investment in research, plant, and equipment into excess spending on housing. This is a drain on U.S. competitiveness. As economist Hal Varian wrote in the November 17, 2005, New York Times: "The money put into building those huge villas on the hillside could have been put into factories, office buildings, and schools."
On the micro level, they pushed borrowers to ever more dangerous levels of debt. Commenting on the mortgage interest deduction, Charles Rossotti, former IRS commissioner and member of the 2005 panel, put it in simple terms: "It encourages people to overinvest in housing."
In an August 18 commentary for PBS, economist Alice M. Rivlin, former director of the Congressional Budget Office, echoed the sentiments of the tax reform panel and framed the proposal in the context of the current financial distress:
As we repair the damage from the bursting housing bubble, we need to focus on how to prevent the next one. . . . We should take this opportunity to scale back the mortgage interest deduction and convert it to a credit so that taxpayers at all income levels get the same tax benefit per dollar of mortgage interest paid. That's simple fairness. Moreover, it might encourage more productive investment and mitigate the next housing frenzy.
President Bush and other major politicians ignored the warnings of Rossotti and his fellow panel members. But it is only fair to ask: If we had less generous tax benefits for home mortgages, would the housing bubble have been inflated to such a dangerous level?
In the corporate sector, the problem of excess leverage received a lot of attention in the late 1980s. Back then the major concern was the unhealthy level of debt incurred by nonfinancial businesses after leveraged buyouts. Although our current crisis primarily concerns financial businesses (see Figure 3), the fundamental tax issue is largely the same. Here is what the Joint Committee on Taxation wrote at the time:
Since the interest expense on debt is deductible for computing the corporate income tax while the return to equity is not, the tax at the corporate level provides a strong incentive for debt rather than equity finance. . . . With higher levels of debt the possibility of financial distress increases, as do the expected costs to the firm that occur with such distress. These additional costs include such items as the increase in the costs of debt funds; constraints on credit, expenditure or operating decisions; and the direct costs of being in bankruptcy.
Nearly two decades later, the Treasury Department would make the same point in a December 2007 report:
Figure 2. Leverage Ratios of Major U.S. Investment Banks,
Source: Company annual reports. The leverage ratio is total
assets divided by stockholder equity.
- The current U.S. tax code favors debt over equity forms of finance because corporations can deduct interest expense, but not the return on equity-financed investment. . . . Excessive reliance on debt financing imposes costs on investors because of the associated increased risk of financial distress and bankruptcy. Firms in financial difficulty may be denied sufficient access to credit, suffer key personnel losses, and endure a diversion of management time and energy away from productive activity. Other costs include legal and administrative expenses associated with bankruptcy, uncertainty regarding the ultimate size of those expenses, uncertainty regarding the marketable value of the firm's assets under partial or full liquidation, and risks regarding the ultimate settlement of competing claims on those assets.
Figure 3. Credit Market Debt Owed the U.S. Finanacial and
As a Percentage of GDP, 1985-2007
Source: Board of Governors of the Federal Reserve System,
Flow of Fund Accounts of the United States, September 18, 2008,
Table 1.1, "Credit Market Debt Outstanding," lines 4 and 10,
And just to round out the picture, we'll give you a quick view of what economic advisers to presidential candidates John McCain and Barack Obama said just before they assumed their current positions. In 2006 McCain economist Douglas Holtz-Eakin wrote that the corporate tax system is "subsidizing leverage." Earlier this year Obama economist Jason Furman told Congress that the "disparity between debt and equity financing encourages corporations to finance themselves more heavily through borrowing. This leverage in turn increases the financial fragility of the economy, an effect we are seeing quite dramatically today."
Even though economists are in near universal agreement on this issue, their complaints about tax biases in favor of debt have resulted in little change.
What can be done to limit the tax incentive for corporations to load up on debt? First, there are limited solutions that can partially solve the problem. These include lowering the corporate tax rate (as proposed by McCain) and limiting interest deductions on some classes of equitylike debt (as proposed in the late 1980s).
Second are the more sweeping proposals that transform the corporate tax and eliminate the bias in favor of debt. These include the dozens of proposals that would effectively eliminate the corporate tax by "integrating" it into the individual income tax. They also include many plans for fundamental tax reform proposed by Treasury and others.
Of course, it would be unreasonable to put the major blame on tax distortions for the current financial mess. After all, suspect code provisions have been in place for decades with no comparable systemic problems. However, there is no denying that the code greased the skids for our downward slide. After the Great Credit Crunch of 2008, politicians may need to take a fresh look at proposals that unwind tax incentives for debt.
- Home equity loans are a subset of total mortgage debt shown in Figure 1, and the data cited in the text are from the same source as Figure 1.
- The Rossotti quote is from an excellent article by David Leonhardt, "Playing the Housing Blame Game," The New York Times, Apr. 2, 2008. If the implicit rental income of owning a home were recognized as taxable income (as theoretically it should be), the deduction for mortgage interest would be a legitimate business expense. For more on the conflict between the politics and economics of the mortgage interest deduction, see "The Economics of the American Dream," Tax Notes, Jan. 24, 2005, p. 407, Doc 2005-1275 , or 2005 TNT 15-9.
- The first long quote about the effect of taxes on corporate debt is from the Joint Committee on Taxation, Federal Income Tax Aspects of Corporate Financial Structures, JCS-1-89 (Jan. 18, 1989). The second long quote is from the December 2007 Treasury report cited below.
- The quotes from the candidates' advisers before they joined the campaigns are from Douglas Holtz-Eakin, "20 Years After Tax Reform: The Case for a Consumption Tax," Tax Notes, Oct. 23, 2006, p. 373, Doc 2006-21151, or 2006 TNT 205-45; and Jason Furman, "The Concept of Neutrality in Tax Policy," testimony before the Senate Finance Committee hearing on "Tax: Fundamentals in Advance of Reform," Apr. 15, 2008.
- Probably the best overview of corporate integration proposals is by Michael Graetz and Alvin Warren, "Integration of Corporate and Individual Income Taxes: An Introduction," Tax Notes, Sept. 27, 1999, p. 1767, Doc 1999-31251, or 1999 TNT 186-89.
- Three Treasury reports that discuss tax reforms that would largely eliminate the distortions in the choice between debt and equity under the current corporate income tax are: Department of the Treasury, "Report of the Department of the Treasury on Integration of the Individual and Corporate Tax Systems," Jan. 1992, available at /taxbasehttp://www.ustreas.gov/offices/tax-policy/library/integration-paper, Doc 92-230, or 92 TNT 6-6; Department of the Treasury, "Treasury Conference on Business Taxation and Global Competitiveness Background Paper," July 23, 2007, available at /taxbasehttp://www.ustreas.gov/press/releases/reports/07230%20r.pdf, Tax Notes, July 30, 2007, p. 399, Doc 2007-17146 , or 2007 TNT 142-14; Department of the Treasury, "Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century," Dec. 20, 2007, available at /taxbasehttp://www.ustreas.gov/press/releases/reports/hp749_approachesstudy.pdf, Doc 2007-27866, or 2007 TNT 246-31.
- For empirical evidence that corporate tax integration reduces debt-equity ratios, see Craig Schulman, Deborah Thomas, Keith Sellers, and Duane Kennedy, "Effects of Tax Integration and Capital Gains Tax on Corporate Leverage," National Tax Journal, vol. 49 no. 1 (Mar. 1996), pp. 31-54.