An Overleveraged Economy: Tax, not just Bank, Reform

By :: January 20th, 2010

I worry whether the recent hearings with the CEOs of the major Wall Street banks, with their focus on blame and personality, will draw attention away from the more important issue:  how we can best insure that money flows from savers to those investors who can produce the highest returns for society.  Certainly bank reform is required. But we’ve got a huge problem with bad incentives, and they apply not just to banks, but to other corporations and even to households.  These incentives make it possible for corporate managers to make big bucks while running losses, allow households to borrow beyond their means, and permit auto companies to pass highly leveraged auto loans to the government.

Many of these perverse incentives for overleverage are embedded in our Tax Code.   Corporate debt is favored over equity.  Mergers and acquisitions and divestitures are often highly-leveraged up front, with juice coming from the tax saving. Commercial real estate is still collapsing, caused in no small part by the ability of most real estate partnerships to avoid income tax in both good times and bad.  They simply remain highly leveraged, which allows them to deduct interest payments at a higher tax rate than their capital gain returns are taxed.  For every $1,000 of interest expense (deductible at a 35 percent tax rate) and $1,000 of capital gain (taxable at a 15 percent tax rate), there is net income of zero, but the tax code still provides a subsidy of $200 (the 20 percentage point difference in tax rates times the $1,000 at stake).  Mind you, that is $200 for wasting society’s resources in extra transactions and playing with others’ money.  Of course, when the capital gains go negative, then some of these firms go bankrupt.

Households can play this game too.  After all, we are encouraged to keep our homes highly mortgaged while at the same time putting money into 401(k) plans and Individual Retirement Accounts (IRAs).  Deduct $1,000 of interest expense and earn $1,000 in those accounts, and we, too, generate tax saving for leveraging up the economy while producing negative growth because we, too, employ people to generate tax saving rather than perform more productive tasks. 

Bad tax incentives are everywhere.  I’d be a lot more convinced that policy makers are serious about avoiding future collapses if they begin to think about systemic reforms across the board. That means a stronger base for equity investment, and fewer incentives for borrowing or playing games of “heads I win; tails society loses.” 

 

7Comments

  1. Anonymous  ::  5:59 pm on January 21st, 2010:

    The other problem with the mortgage deduction is its distribution. The housing and housing leveraged borrowing goes to upper income tax payers, while lower income tax payers get no subsidy for their housing. Shifting the interest tax expenditure to children rather than housing debt, by beefing up the child tax credit, will keep housing well fed (since the biggest expense of growing families is housing) with better equity results and a decrease in leverage in general. Of course, such a move will also discourage consumer debt by the wealthy – but this will be more than offset by increased spending by families with children.

  2. Anonymous  ::  7:36 pm on January 21st, 2010:

    Michael, I am still unsure as to why you want to increase the child tax credit to solve all the problems. While I agree with the notion of eliminating the mortgage deduction, why shift it to a child tax credit? You say it is to help the poor, but why not make the credit dependant on level of income, not level of procreation? This would seem to have the same equality results with a decrease in leverage. Unless, of course, the goal is to better link household size with home ownership, which I disagree with, I think.

  3. Anonymous  ::  8:12 pm on January 21st, 2010:

    With regard to the post, the VAT would seem to take care of many of the issues presented, but that seems like an unrealistic solution. As long as ordinary and capital rates, treatment of debt and equity costs, and incentives of consumption and savings differ, there will be arbitrage.
    Although, maybe your point is to better align the arbitrages with the goal of “who can produce the highest returns for society.” If it is better to push taxpayers to save or invest their money, rather then spend it on shinny objects, then the tax code should do so in some simple and controlled manner. Once the money is saved, it is the job of the financial markets to distribute the capital and it the job of other regulators (i.e. not the IRS) to make sure it is done so efficiently.
    However, I agree that corporations should look at financing in a tax-neutral manner. With the tax code out of the leverage question, then a single regulator (again, not the IRS) can be more efficient at targeting the 'correct' amount of leverage.

  4. Anonymous  ::  2:54 pm on January 22nd, 2010:

    Because having more kids solves the demographic problem facing federal retirement and health programs, as these kids become first the objects of consumption and then workers, who can then feed the FICA Ponzi scheme. This provision would also lower the abortion rate – and do so much more effectively than any abortin ban. This is important to some people – many of whom voted for Obama.

  5. Anonymous  ::  4:32 am on January 24th, 2010:

    Michael,
    What about the environmentalists who say we have an over-population problem?
    Furthermore, by your argument of solving the ponzi-scheme, the child credit cap should be removed given that children of high-income people are more likely to have higher incomes than children of lower incomes. In fact, maybe the subsidy should increase as incomes go up.

  6. Anonymous  ::  3:52 pm on January 26th, 2010:

    We do not have an overpopulation problem, especially in the Western world. Indeed, we may currently be in a cooling cycle. 200 years ago, we were in a period of partial glaciation and have not yet reached the levels of the hot period previous to it. As long as there is snow in England at any time, we are not yet warm enough.
    I'm all for raising the child credit income cap. Indeed, family credits should be on an employer-based tax, with individual taxes only on incomes over $75,000 for individuals and $150,000 for families. I would say 6% at that level, although the White House would insist on 3% (the current level once you back out VATs (10%), payroll taxes (15%) and Business Income Taxes (15%).

  7. Anonymous  ::  3:14 pm on February 1st, 2010:

    Here's one for you. Why can we not recognize all Government mandated expenses levied on biz for what they really are-> Full blown transaction taxes! Take SS/Med paid via biz for example. Biz simply passes the cost on netting a cost of zip due to being reimbursed. Biz after biz does the same so by the time any given product or service is eventually paid for the consumer is paying the cumulative cost for all Government mandated expenses and then some via the base price. The consumer must be the ultimate payer but I ask why increase the cost of operations to biz when the consumer could obviously pay a far lower base price if a RETAIL NST were used to fund that which is currently funded via a transaction tax methodology? Might this simple change cause business to return to this country amongst other potentially positive benefits?