[R-G] [BillTottenWeblog] The Debt Economy

[Bill Totten]

by James Surowiecki 

The New Yorker (November 23 2009)


John Kenneth Galbraith wrote that all financial crises are the result of
"debt that, in one fashion or another, has become dangerously out of
scale". The recent financial crisis was no exception, with everyone -
homeowners, private-equity investors, our biggest banks - taking on
enormous amounts of debt. If it's frustrating that the government is
footing the bill to clean up the mess, it's even worse that the government
helped pay for the debt binge that created the mess in the first place,
thanks to a tax system that actually subsidizes borrowing. Debt didn't get
dangerously out of scale because the system was broken. It got out of
scale, in part, because the system worked.

The government doesn't make people go into debt, of course. It just nudges
them in that direction. Individuals are able to write off all their
mortgage interest, up to a million dollars, and companies can write off
all the interest on their debt, but not things like dividend payments.
This gives the system what economists call a "debt bias". It encourages
people to make smaller down payments and to borrow more money than they
otherwise would, and to tie up more of their wealth in housing than in
other investments. Likewise, the system skews the decisions that companies
make about how to fund themselves. Companies can raise money by
reinvesting profits, raising equity (selling shares), or borrowing. But
only when they borrow do they get the benefit of a "tax shield". Jason
Furman, of the National Economic Council, has estimated that tax breaks
make corporate debt as much as forty-two per cent cheaper than corporate
equity. So it's not surprising that many companies prefer to pile on the
leverage.

There are a couple of peculiar things about these tax breaks - which have
been around as long as the federal income tax. The first is that they're
unnecessary. Few people, after all, can save enough to buy a home with
cash, so home buyers naturally gravitate toward mortgages. And businesses
like debt because it offers them tremendous leverage, making it possible
to put down a little money and potentially reap a huge gain. Even in the
absence of the deductions, then, there would be plenty of borrowing. The
second thing about these breaks is that their social benefits are pretty
much nonexistent. Advocates of the mortgage-interest deduction, for
instance, claim that it increases homeownership rates. But it doesn't: in
countries where mortgage deductions have been eliminated, homeownership
rates haven't dropped. Instead, the deduction simply inflates house
prices. The business-interest deduction, meanwhile, may lower an
individual company's taxes, but it also means that the over-all corporate
tax rate is higher, so its real impact is to give companies with lots of
debt an unjustified advantage.

If the benefits are illusory, the costs are all too real. Economies work
best, generally speaking, when people are making decisions based on
economic fundamentals, not on tax considerations. So, as much as possible,
the tax system should be neutral between debt and equity, and between
housing and other investments. It's not, and, worse still, as we've seen
in the past couple of years, debt magnifies risk: if companies or
individuals rely on large amounts of leverage, it's much easier for bad
decisions to lead to insolvency, with significant ripple effects in the
wider economy. A debt-ridden economy is inherently more fragile and more
volatile. This doesn't mean that the tax system caused the financial
crisis; after all, the tax breaks have been around for a long time, and
the crisis is new. But, as a recent IMF study found, tax distortions
likely made the total amount of debt that people and companies took on
much bigger. And that made the bursting of the housing bubble especially
damaging. So encouraging people to take on debt qualifies as a genuinely
bad idea.

But it's not an easy situation to change. In 2005, a special Presidential
panel on tax reform actually proposed eliminating the business-interest
deduction and severely restricting mortgage-interest tax breaks. Those
proposals, predictably, went nowhere. But we're in a different historical
moment now: the perils of too much borrowing have never been clearer. And
there are precedents, on a smaller scale, for these kinds of changes. In
the US, people used to be able to write off the interest they paid on
credit cards. That tax break was abolished in 1986, and, the same year,
the mortgage-interest deduction, which used to be unlimited, was capped.
Great Britain, meanwhile, abolished its mortgage tax break in 2000.
Similarly, there are a number of countries, including Brazil and Belgium,
that don't give corporate debt a tax advantage over equity, while, just
last year, both Germany and Denmark cut back sharply on their
business-interest tax breaks, limiting how much interest companies can
write off. Given the weak state of the economy and of housing prices, a
wholesale rewriting of the tax code may be a bridge too far right now, but
there are plenty of reforms - capping deductions, phasing them out over
time, restricting their use by heavily leveraged companies - that would
move in the right direction.

The clearest hurdle to these changes may be political, but the bigger
hurdle is, in a way, psychological: because tax breaks on debt have been
around so long, we can hardly imagine what it would be like if we changed
them, and we tend to underestimate their influence in shaping our
behavior. Subsidizing debt seems harmless simply because we've always done
it. But the fact that you've had a bad habit for a long time doesn't make
it less dangerous.

http://www.newyorker.com/talk/financial/2009/11/23/091123ta_talk_surowiecki

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