How the tax system makes finance more dangerous

Simon Johnson, a leading U.S.-based intellectual, has written an excellent piece in the New York Times with the above headline. It concerns an issue we've written about several times in the past: that the tax system in many countries has encouraged a bias towards debt, rather than equity financing. The resulting indebtedness made the financial system more dangerous, and we are now finding out the consequences of this.

The simple reason is that borrowing is, in many cases, tax-deductible, whereas equity financing is not. So instead of raising money through the stock market, say, they borrow it.

And banks, of course, are among those over-borrowers. And this creates risks to society - a form of economic pollution. Johnson notes:

It is also ironic — perhaps even bizarre — that while we try to constrain how much banks borrow through regulation, we give them strong incentives to borrow more through the tax code.

(He also notes two reports just published by the Joint Committee on Taxation, one on business debt and one on household debt.)

There are two ways to tackle the debt bias problem: eliminate or curb the tax deduction for debt, or make an equivalent deduction for dividends. We have favoured the former - which among other things seems like a good idea in the current deficit-plagued situation.) Johnson has more.

"I [propose] that we go further and consider a tax on “excess leverage” in the financial sector. The idea — already being applied by some European countries and further developed by some of my former colleagues at the International Monetary Fund — is based on the premise that a high level of borrowing relative to equity is a form of pollution, creating negative spillovers for the rest of the economy."

In other words, if a bank is borrowing too much - which in practical terms means it has huge borrowings, when compared to the size of its equity capital safety buffer - it should be taxed on this, above and beyond the regulatory requirements to have larger capital buffers than before. He proposes something that (at least in the current environment) would be seen as setting quite a high bar:

"companies of any kind would be taxed on debts that exceeded some reasonable multiple of their equity (perhaps a multiple of three or four). . . . the same logic [as applied to banks] applies to insurance companies, hedge funds and even leveraged buyout firms."

It is right that the bar should be high, in light of all that's happened.