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.”