It is hard to imagine a financial crisis that is not ultimately caused by creditors who had taken on too much debt. Debt is the root cause of most corporate financial failures and, if a snowball effect sets in, the root cause of financial system failure. Of course, debt also has advantages. Without debt, many privately and socially valuable projects could never be undertaken. Still, it is our current tax system that has pushed our economy to be too levered. Now is the time to address the problem—before it will again be too late.
From a creditor’s perspective, the two key advantages of debt are the tax deductibility of interest payments and the ability of lenders to foreclose on non-performing borrowers (which makes it in their interest to extend credit to begin with). Although both factors contribute greatly to the incentives of the borrower to take on debt, there is one important difference between them: the tax deductibility of debt is not socially valuable.
To explain this issue, let’s abstract away from the beneficial real effects of debt and consider only the tax component. In an ideal world, taxes should not change the decisions of borrowers and lenders. They would take exactly the same projects and the same financing that they would take on in the absence of taxes. At first glance, one might argue that the tax distortions of leverage are not so bad, because the interest deductibility of the borrower is offset by the interest taxation of the lender. But this “wash argument” is wrong. It ignores the fact that capitalist markets are really good at allocating goods to their best use. In this case, it means that the economy will develop in ways that many lenders end up being in low tax brackets (such as pension funds or foreign holders) ,while many borrowers end up being in high tax brackets (such as high-income households or corporations). The end result will be not only that the aggregate tax income is negative, but that debt is taken on by borrowed primarily to reduce income taxes and not because debt has a socially productive value.
What then can we do to improve our social outcome? The answer is simple: eliminate both the tax deductibility of interest and the taxation of interest income. The net effect would be an increase in governmental tax receipts. (Incidentally, because the US has become a net world debtor, much of the interest income was already untaxed, anyway.) Taxes were paid disproportionally by senior citizens who depended on this income. Politically, they would provide a natural base of support for such a tax proposal. Of course, existing highly indebted corporations [like banks and LBOs] would lobby heavily against such a proposal. Long-term, seniors would accept lower interest rates, creditors would pay lower interest rates (though not after taking the interest deductibility into account), and tax receipts would be higher. The increased debt receipts could be used to reduce the deficit or income taxes.
However, there is a second important social cost of debt. It arises from contagion effects. Borrowers and lenders are not likely to be fully aware of or considerate of the effects that their own failures could force onto other firms. Thus, if a few large firms fail, especially if a few large banks fail, it could further restrict credit and force other firms to fail in turn. The result would be a potentially catastrophic downward spiral of the kind of which we had a good taste in 2008. It was bad—but it could be worse.
This “contagion externality” suggests we should discourage debt even more than what I already argued we should discourage debt due to the tax distortion. We may want to deliberately disadvantage debt. The easy way to do this would be to retain the taxation of interest income, but eliminate the tax deductibility of interest payments. This would discourage debt as a method of financing, and put it on more equal ground with equity. After all, we do not allow borrowers like firms to deduct dividend payments, and yet we still tax dividend and capital gains receipts. Frankly, the current tax system that favors debt over equity is not only logically absurd, it is also socially harmful.
An intermediate proposal to deal with the contagion risk of leverage would be to divide debt into a component that is safe and a component that is unsafe. This is surprisingly easy to do. If a corporate bond pays 6% while the comparable Treasury bond pays 2%, then the unsafe component is worth 4%. We could then allow firms to deduct interest payments of only 2%, not the full 6%. This would discourage firms and banks to take on debt that is so risky that it has a significant impact on the paid interest rates—and so risky that it can take down the firm. It would especially discourage LBOs. These highly levered firms have often taken on debt that is so risky that it could almost be called equity. The tax deductibility in these buyouts if often a major source of gains that accrue to the owners (but not society). Again, it is absurd that we use the tax code to encourage LBOs. This is not to say that all LBOs are bad. But we only want LBOs that are taken on because they make firms run more efficiently, not because they shelter more taxes.
Of course, there are some difficulties in implementing this tax change, too. First, I have ignored liquidity premia in corporate bond rates. We could live with the fact that we may discourage leverage too much (my preference), or we could offer an arbitrary modest additional premium allowance (say 100 basis points), or we could use some unusually illiquid government bond instead of the liquid Treasury. Second, I have ignored other features in bonds, such as equity kickers in convertible bonds that drive down the paid interest rate, or zero-coupon bonds that delay payment. This would require reasonable tax regulations and valuation methodologies—of the type that corporations already have to produce for the IRS today to deal with the very same issue of complex tax arbitrage.
Of course, no rule is perfect. But reducing the tax deductibility of interest only to the part of interest that is “safe” is a step in the right direction.