As Charlie Gasparino explains ("Three Decades of Subsidized Risk") in today's Wall Street Journal, Fed-subsidized rock-bottom interest rates and implicit government guarantees for those too big to fail fueled a corporate borrowing binge that almost brought the U.S. economy to its knees. The tax bias for debt over equity financing has also contributed to the problem, as noted in two other commentaries published this week. In the Financial Times, Clive Crook shined a light on this neglected issue:
- At least the need to raise capital is well understood. A second main cause of the financial meltdown is barely even recognized. On this, one can only pinch oneself. Too many US households and financial institutions got too deeply in debt. Housing-related debt was especially implicated in the mess. And it just so happens that debt in general, and housing-related debt in particular, attracts enormous implicit subsidy, especially in the US. Before one starts to tinker with complex evadable mandates on this and that – cranking up the regulatory machinery with all the unintended consequences this would doubtless have – one surely ought to look hard at the tax policies that actively encourage indebtedness.
- [T]here was too much debt in the system. "There is a huge bias in the tax system towards debt," [Adair] said, largely because companies can deduct interest payments before computing taxable profits. "If we can't change that, then the regulatory approach needs to lean against that." Hence all the talk of reducing the leverage of financial firms. While U.S. and U.K. households and businesses did borrow more during the boom, the big run-up was in borrowing among financial firms matched by a huge increase in trading relative to the value of underlying economic activity, he observes.
There is almost universal agreement that the U.S. must reduce its corporate tax rate. Over the last decade every major country, except Japan, has cut its corporate tax rate. Now instead of having one of the lowest corporate rates in the world (as it had after passage of the Tax Reform Act of 1986), it now has the second highest. Even President Obama has expressed interest in lowering the rate.
But the problem, as always, is money. What revenue source will replace the revenue lost from the lower rate? In 2007, when Germany lowered its corporate tax rate from 39 to 30 percent, it helped pay for the lost revenue by limiting deductions for corporate interest. That change was pre-Lehman. Now that we have all been educated by the crisis it is clear the benefit of such a move is not just more revenue but less debt. The President's Advisory Panel on Tax Reform should recommend that U.S. follow Germany's lead. Limiting interest deductions would allow lower corporate rates and help reduce financial risk.