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After the financial crisis erupted in 2008, many observersblamed the crisis in large part on the fact that too many financial firms hadloaded up on debt while relying on only a thin layer of equity. The reason isstraightforward: whereas equity can absorb a business downturn – profits fall,but the firm does not immediately fail – debt is less forgiving, becausecreditors do not wait around to be paid. Short-term creditors cash out orrefuse to roll over their loans, denying credit to financially weakened firms.Long-term creditors demand to be “made whole” and sue. Without cash, the firmfails.
Financial firms in the UnitedStates pay about 34% of their profits in taxes, and, while they can deductinterest payments to creditors from taxable income, equity is not taxed asfavorably. Most countries have similar tax preferences for debt over equity,thereby encouraging financial and other corporations to use more debt, asfinancial analysts have long known.
And yet the argumentthat this tax preference for debt played a role in the financial crisis – andthat it remains an ongoing risk to financial stability – was quickly rejected.After all, the tax preference for debt has existed for a long time, and nothingheightened it before the crisis hit. On the contrary, if anything, the taxpreference has decreased somewhat over time. And the crisis was quite clearlytied to the explosion in risky mortgage-backed securities in the US; when themarket abruptly realized that these securities could not be paid off in full,many systemically important financial firms were seen to be much weaker thanthey had seemed. Catastrophic economic consequences followed.
All of this is true,but, given the possibility of a major overhaul of US corporate taxation, whichPresident Barack Obama has proposed, we should revisit the conventional wisdomconcerning the supposedly weak connection between corporate taxation and thefinancial crisis. Indeed, in my view, policymakers, academics, and the mediahave rejected too resolutely the idea that corporate taxation played no morethan a minor role.
To be sure, the taxpreference for debt has been embedded in the economy for a long time, with nofinancial crises for most of that period. And, yes, tax incentives are not the only – and perhaps noteven the most important – reason why financial institutions use a lot of debtand minimize equity. Most important, while reliance on debt made financialinstitutions riskier, creditors knew that, in a crisis, the government wouldprobably bail out the largest, if not all of them. Government was less likelyto bail out equity.
Viewed from thisperspective, it is no wonder that the question of how debt is taxed has playeda small role in financial-reform packages. Financial institutions fell off thecliff in 2008, it is argued, because they got too close to the edge.Destabilized by too much short-term debt and too much exposure to risky,overvalued, low-quality mortgage-backed securities, they tripped and fell overit. So regulators have focused on command-and-control orders to financial firmsto increase their equity, and to reduce the riskiness of their investments.
But consider anotherway of viewing the crisis and our financial institutions: the financial systemwas neverall that far from the cliff’s edge, even before 2008, because the tax systemencouraged financial firms to overload themselves with debt. They generallymanaged themselves and their risks well, so they did not fall. But then, in therun-up to the crisis, they miscalculated, taking on too much short-term debtand over-investing in risky securities. The added risks pushed the financialsystem past the tipping point, but the baseline problem was that it alwayscontained too much risky debt.
From this perspective,it becomes clear that the baseline tax-induced risks should not be ignored. Thepolicy consensus has properly focused first on the new risks that were added.But focusing on those added risks should be only the first step; doing soshould not lead us to ignore the baseline risks that the tax system creates.
The taxation issuemay go deeper. The tax system first encourages financial firms to use more debtthan is safe, but there is a parallel effect on non-financial firms and manyhomeowners. Tax deductions for interest payments encourage them to borrow, too,an issue that has long been understood. But, less obviously, these borrowersthen demand more tax-induced lending from financial institutions, because taxbenefits make their own use of debt cheaper. Were their demand for debt lower –and, in the case of corporate debtors, were they to rely more on equity –financial institutions would face less pressure to use so much debt themselves.
Much considerationhas already been devoted to how to reform corporate taxation in a way that levels the playing fieldfor equity relative to debt; more than 20 years ago, the US Treasury conducted a major analysis and devised a plan to do so. As the Obamaadministration moves ahead with its new proposals, it should look back at thefinancial crisis, which provides strong grounds for implementing such a change.
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