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The Tax Code ENCOURAGES Leverage
Among the most prophetic voices prior to the economic crash was UCLA economics professor Harold H. Somers, who warned in 1991 that revisions to the tax code would increase leverage, which could lead to economic disaster:
The
result is to tilt the well-worn playing field even more in favor of
leveraging, leading to the possibility of another leverage frenzy and
debacle at some time in the future.
Professor Sommers explained:
The
complete history of the causes of the junk bond debacle of 1989 and
1990 is yet to be written. But the tax incentive must have a prominent
place in any comprehensive work. This comment applies to long-term debt
where the interest deduction can be a major factor; short-term debt may
be dominated by other considerations.What is involved is
essentially the shield against income tax that is provided by corporate
debt compared with the shields that are provided for equity by the
income tax rules ...
Former President of the St. Louis Federal reserve Bank - William Poole - agrees in a new paper:
A
straightforward fix for excessive leverage can be achieved through the
tax system. Companies borrow, in part, because they believe that debt
capital is cheaper than equity capital. That is certainly the case
under the U.S. corporate tax system because interest is a deductible
business expense in calculating income subject to tax whereas dividends
are not deductible.
Excessive leverage is highly destabilizing to the financial system (see this, for example). If a simple fix to the tax code could substantially reduce leverage, I'm all for it.
Poole recommends the gradual phasing-in of changes to the tax code to reduce leverage:
Interest
deductibility could be phased out over the next 10 years. Next year, 90
percent of interest would be deductible; the following year, 80 percent
would be deductible, and so forth, until interest would no longer be
deductible at all. The same reform would apply to all business
entities; partnerships, for example, should not be able to deduct
interest if corporations cannot.
With this simple change, the
federal government would encourage businesses and households to become
less leveraged. We have learned that leverage makes not only individual
companies more vulnerable to failure but also the economy less stable.
We use tax laws all the time to promote socially desirable behavior;
eliminating the deductibility of interest would reduce the risk of
failure of large companies—especially, large firms—and thereby reduce
the collateral damage inflicted by such failures.
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Make interest NON deductible.
Make dividends TAX FREE.
The mortgage interest rate deduction should be eliminated gradually. It pushes up the price of houses artificially and also richly rewards the better-off. Now is a good time to deal with this because house prices are already approaching a realistic level and the Govn needs more money.
Why is it that those formerly and often currently of the St Louis Fed speak sense when the NY Fed is so far up Wall Streets ass it could floss its teeth.
Seems like everytime Tyler has a graph with a skein of honest (and shocking) data, its from the St Louis Fed. Bet New York doesn't send them Christmas cards.
Can you imagine what would happen to real estate valuation if we suddenly eliminated the tax benefit to having a long-term mortgage!? That would be so cool (for me).
Funny how the arrow of entropy only points one way. If the problem is that interest payments are deductible and dividends are not, the answer couldn't possibly be to make dividends equally deductible.
Convert common into preferred.
That's ENCOURAGES btw...
I am not sure this works today. In 1991 the cost of debt was 6%. Because of the tax shelter, the real cost was only 4%. You want to eliminate the tax break and make the cost of debt go back to 6%. That would discourage debt. Mr. Sommers is correct.
But this is 2010 and we have near zero interest rates. Today the debt cost is only 2%. With the tax shelter it goes to 1.5%. It does not matter.
In this case the relative cost of money overwhelms the pre and post tax issue. When interest rates are near zero it is always wise to borrow as much as you can.
true today, yes, but let's not assume that we will be in ZIRP forever. Frankly, you can make the argument that it should be done immediately precisely because we have low interest rates - it will cause the least disruption of exisiting debt, capital structures, and profitability.
Actually, if the tax shield of debt was ever to be phased out, now is the best time.
The same situation applies wrt residential mortgage deductions.
Of course, doing the right thing usually doesn't coincide with the popular thing to do.
Removing the deduction of interest is half the equation. The other half is to make dividends and simple interest tax free. Capital gains tax rates should be reduced or eliminated as well. All to spur savings (which is the true capital for expansion as opposed to debt).
As with all plans for the government, the outcome will probably be the opposite of what is intended.
Remove interest deductions and you will have less buying. This would include any item that is normally financed: Business equipment, homes, cars etc. This would be good in a non-fantasy world where money earned is what can be spent or saved. It would be pretty tough changing the habits of US citizens to the mode of "live within your means". I think it would be good despite the pain, but I don't think we'll choose pain early. Rather, we'll wait for maximum pressure and be forced to choose maximum pain.
There was a day when man revolted over Taxation without Representation
He has combined with others to subject us to a jurisdiction foreign to our constitution and unacknowledged by our laws; giving his Assent to their Acts of pretended Legislation... For imposing Taxes on us without our Consent.... We, therefore... solemnly publish and declare, That these United Colonies are, and of Right ought to be Free and Independent States. ~The Declaration of Independence of the Thirteen Colonies, 1776
Can this Representation without Taxation practiced today be any less heinous? Less unjust? Hark, when shall we heed Franklin's warning? Whence came a Revolution?
I'll put this in the "too common sense too simple to ever be the policy of the government" bucket.
But yes, the interest duductability of debt is totally bizarre and destructive.
That is, leverage to the point of insolvency while
GE, GS, GM paid less than 1% taxes....